How business loans work and the types you can apply for
With many types of business loans available, understanding each can be a challenge. Learn more about the different types and how business loans work.
Updated 
7 min. read
Business loans allow new and established businesses to access capital, whether to launch an enterprise, expand current operations, or finance another business opportunity.
How do business loans work? Every financial institution offers different types of business loans, including short-term financing, such as a business line of credit, and long-term installment loans, which the borrower pays off over a set time period. The requirements to qualify for financing will vary by type of business loan and financial institution.
Here's an overview:
How do business loans work?
The process for how business loans work will typically include the steps listed below, although each financial institution will have its own procedures. Remember to read the requirements carefully for a loan to make sure you understand the criteria to qualify and the requirements for repayment.
- Business loan application: A business completes and submits a financial institution's loan application. The application can be paper or digital, depending on the lender. Contacting the lender is a good way to know your options and decide which is best for your business.
- Application evaluation: The financial institution reviews the application and the business’s financial data and provides a credit decision. A credit approval includes the approved amount, interest rate, fees, and repayment terms.
- Due diligence review: If the applicant decides to move forward with the loan, the financial institution will perform a due diligence review on each borrower, guarantor, or grantor, and — if required — collateral. The bank will then prepare the loan documents to be executed at closing.
- Disbursement of funds: Once the loan closes, the business will receive the funding as either a lump sum or a line of credit that they can draw upon as needed.
- Repayment: The business will then pay back the loan or line of credit, according to the payment terms outlined in the loan documents. With a revolving business line of credit, you can make draws up to the credit limit and borrow funds again after you make principal payments. Businesses that fail to repay a loan under the terms may be in default, which could result in the lender taking action to seize collateral or other assets.
Factors that might impact loan qualification
Financial institutions will typically weigh these factors when they consider a loan application.
1. Credit score
Financial institutions often use an owner’s—and any guarantor on the application—personal credit score to help determine their qualifications. Businesses that have been established for a year or longer may have built sufficient credit history to generate a business credit score that could also be considered when applying for a loan.
2. Business plan
A comprehensive business plan will include an executive summary, sales strategy, financials, target audience, marketing plan, pricing strategy and a SWOT analysis (strengths, weaknesses, opportunities and threats).
3. Cash flow
A financial institution will want to get a sense of your company’s cash flow and whether you're prepared for a seasonal slowdown or unforeseen circumstances that could impact your cash position.
4. Collateral
Many businesses may need to pledge collateral, which could be real estate, equipment or a vehicle, to qualify, which is called secured financing. In secured financing, the failure to pay back the loan can result in losing the collateral to the lender. Very established businesses may be able to qualify for unsecured financing, which does not require collateral, but it may come with higher interest rates, lower credit limits, and shorter repayment periods.
5. Loan amount
Your plans for the funds will help determine the amount a business would like to borrow. You can use a business loan calculator to estimate the potential cost of financing based on the amount you want to borrow.
6. Business size and location
To qualify for certain types of loans, such as those backed by the U.S. Small Business Administration or those from a regional financial institution, your business may need to meet certain size or location requirements.
7. Other debt
Lenders may factor in personal and other business debts carried by the owners or guarantors.
8. Industry
Financing options may be restricted or unavailable for high-risk industries. The applicant’s industry will be evaluated by the financial institution, and it may impact the credit decision or amount of credit offered.
Thinking about applying for a loan?
Use a business loan calculator to estimate the potential cost of financing based on the amount you want to borrow.
Types of business loans
When it comes to business lending, entrepreneurs have multiple options. Here are some of the most common business loans and how they work:
Term loan
A term loan is a lump sum of money a business borrows and then pays back over a fixed period of time with interest.
SBA loan
The U.S. Small Business Administration (SBA) backs certain types of business loans to help encourage lending. The agency provides guidelines for the financial institutions that do the lending, and helps guarantee a portion of the loan to reduce the lender’s risk. In the event of a default, the SBA does not assist the applicant with repayment. Businesses seeking an SBA loan can apply for amounts ranging from $500 to $5.5 million.
Line of credit
A business line of credit is a flexible funding tool that lets a business borrow funds as needed up to its approved credit limit. Just like a credit card, you only pay interest on the amount borrowed, and after you repay the principal, the credit line is replenished, and you can make additional draws, subject to the terms of your credit agreement.
Microloans
These are smaller loans, typically up to $50,000, that are often provided by non-profit groups and community-based lenders, sometimes in partnership with the SBA. footnote 1
Real estate loan
Businesses can borrow funds to purchase or refinance commercial properties that they already own.
Equipment leasing
This form of financing allows you to receive up to 100% financing to lease equipment, vehicles and technology, as well as "soft costs" like maintenance and warranties. footnote 2
Common business loan terminology
Here are some common terms associated with loans:
- Loan agreement: This is a legally binding contract that lists the terms and conditions for a business loan, including the approved amount, interest rate, fees and repayment schedule.
- Loan principal: This is the amount you borrow from a financial institution. The principal balance owed on the loan will decrease over time as the loan is repaid.
- Interest rate: A business loan with a fixed interest rate will maintain the same rate over the course of the loan, while a variable rate loan’s interest rate fluctuates based on changes to the loan’s benchmark interest rate. This benchmark is often, but not always, the prime rate, which is based on Federal Reserve decisions. footnote 3
- Fees: A business loan could incur various fees, depending on the type of loan and financial institution. Some fees may be one-time, such as an origination fee, document prep fee or closing fee, while others might recur, such as a late payment fee, if the borrower doesn’t make their payment by the due date or within the allotted grace period.
- Repayment terms: This lists the specific details of how a borrower must repay their loan. It includes the amount of time in which the loan must be repaid and the amount of each periodic payment.
- Installment loan: For this type of borrowing, you receive the total amount of the loan upfront and then pay it back in a set number of installments to cover the principal and interest.
- Revolving credit: This is a type of financing in which you only withdraw the amount you need. Once you’ve made principal payments on the funds you’ve drawn, the credit line is replenished, and you may be able to draw the funds again, subject to the terms of your credit agreement.
FAQs
The amount you can borrow with a business loan will vary by type of loan and the financial institution. For example, the amount you may be eligible to borrow with an SBA loan ranges from $500 to $5.5 million, while a microloan typically maxes out at $50,000.
A small business loan may have a fixed or variable interest rate, depending on the type of loan and the lender.
The documents you might need for a business loan may vary by type of loan or lender and may include a completed application, articles of incorporation or other business formation documents, collateral information, a business plan, two or more years of financial projections, a business tax return, a personal tax return and other documents as requested.
A business could affect your personal credit if you were to use personal assets for collateral or guarantee the loan yourself. footnote 4
The amount of collateral needed for a business loan depends on the financial institution and type of loan, and could be equal to or above the amount requested by the applicant.
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