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Most small business owners (64.4 percent) get capital from their personal and family savings. Using business loans is the second most common way of securing funding, as 16.5 percent of small-business owners take out loans. The remaining small-business owners utilize personal credit cards (9.1 percent) or personal family assets (8.7 percent).
If you’re starting a business, you’ll need to decide which method of financing is best for you. Taking out a business loan isn’t the worst thing, and it can help you secure the funding you need. However, it’s likely to cost you a significant amount of money in the long run. You should only apply for a business loan if you truly need the extra cash.
How hard is it to get a business loan?
Taking out a business loan is often a headache, and the process can take a long time. It’s normal for business loans to come with a long list of requirements and qualifications that are difficult to meet. Improving your credit score, creating a detailed business plan, and organizing all of your business documents are a few things that you can do to help your odds of being approved.
Unfortunately, your loan application is still likely to be rejected even if you follow those tips to the letter. The approval rates of small business loans in the second quarter of 2021 were pretty disheartening. Credit unions, small banks, and big banks had the lowest approval rates as they only reached 20.5 percent, 18.9 percent, and 13.6 percent, respectively. The highest approval rates were alternative and institutional lenders, but they only made as high as 24.5 percent and 23.8 percent.
The point is that you will need to be flexible when applying for a business loan. Shop around different lenders, look into different types of loans, and adjust your application. The first thing you’ll need to do is estimate your monthly payments to know if you can afford to repay the loan.
How to estimate your monthly business loan payments
Calculating your monthly business loan payments will require three different pieces of information: the loan amount, terms, and the annual interest rate. You’ll be negotiating all of these numbers during the first stages of your loan application. It’s common for lenders to adjust them before they accept your loan.
For lenders, a business loan is essentially an investment opportunity. Their goal is to make money from the interest you’ll be paying them. They will decline your application if they believe you are a risky investment. You would have to make adjustments to create a new application, or they would provide you with a counteroffer.
These are the three most critical numerical values involved with a business loan:
- The loan amount is the total amount of money you initially borrowed from the lender. Let’s say that you need to upgrade the kitchen in your restaurant and estimate the costs to be $20,000.
- The loan term is the expected period of repayment for the loan and is usually expressed in months. The longer the long term, the longer you will have to pay it back. Let’s say you feel confident you can repay your loan in five years (60 months).
- The annual interest rate is the fee you pay to the lender to provide you with the loan. The interest rate will vary on several factors, including your credit history, the loan amount, terms, and whether you offer any collateral. Let’s say your lender gives you a 7 percent annual interest rate.
The formula for calculating your monthly payment is loan balance X (annual interest rate/12). It’s a bit complicated, and you’ll need to use the formula for each month of the term to calculate your average monthly payment. Based on the examples listed above, you would have a loan amount of $20,000 with a loan term of 60 months and an annual interest rate of 7 percent. By following this formula, your monthly payments would end up being $394 each, and you’d pay a total of $3,639.89 in interest.
Business loan repayments are structured to pay the most interest first and the principal last. This example illustrates the first monthly payment of $394 would be $280.92 in principal and $113.08 in interest. As the principal balance of the loan is slowly lowered with each payment, the total interest due will also decrease. That means the final monthly payment (still $394) would be $391.78 in principal and $2.22 in interest.
What are the different types of business loans?
The most common type of business is called a term loan. You establish the total amount for the loan, set the interest rates, and create a timeline for repayment. While this formula is pretty similar to most loan types, there are still some critical differences between them. Depending on what you need the money for, a business loan might be available to save you time and money.
SBA loans are business loans backed by the United States Small Business Administration. Because some of the loans are backed by the government, the risk will be lower for the lender. As a result, the lender is usually more willing to accept loan applications than it would normally reject. You will still need a good credit score to be taken and should aim for at least 680 before you apply.
It’s possible to take out an SBA loan for any amount up to $5 million. There are typically more stringent requirements for more significant sums of money. The interest rates will vary based on your credit qualifications and the loan amount. A loan for less than $25,000 usually comes with a fixed rate maximum of 8 percent plus the prime. A loan for more than $250,000 usually comes with a maximum of five percent plus the prime. The loan terms are also very generous, as you can request a loan term of up to 25 years.
The most significant downside is that SBA loans come with tedious paperwork and qualifications. You’ll need to jump through many hoops and wait for several months before knowing if you qualify.
Working capital loan
Working capital loans are short-term loans used to cover daily operations costs. They’re usually used to fund everyday operational expenses like payroll, rent, and utilities. The best example would be a seasonal business that might use a working capital loan in the off-season. Since cash flow might be complex during the offseason, they can use a working capital loan to help keep the business running.
Usually, a working capital loan will only come in 12 months or less. Since the term is so low, it will mean that the interest rate is much higher. It will vary broadly based on your credit score, but you can expect an interest rate between 16 percent and 35 percent. The cap for the total amount will vary based on where you’re looking. Working capital loans are available anywhere from four figures to seven figures depending on how much you need.
Every business will need to use several different pieces of equipment. It can range from carpenter’s tools and office electronics to vehicles and manufacturing machinery. Equipment financing is a loan used to purchase necessary equipment for your business.
The good thing about needing a loan to buy equipment is that you can use these items as collateral. By offering the equipment as collateral, the lender will assume less risk. It can help to increase the odds of your loan being approved and sometimes lower the interest rate. The exact rate can vary, but it’s common for interest rates to range between six and nine percent. Loan amounts usually range between $10,000 and $500,000, and the term lengths typically last between two and seven years.
The one major downside to equipment financing is that you’ll need to make a down payment. The standard down payment is usually somewhere between five and 20 percent. Depending on the cost of the equipment, this can easily reach into the five-figure range.
Get a loan that you know you can afford
No one can accurately predict the future. There’s no way to know how your business will be doing five minutes from now, let alone five years. It will be challenging to determine the limit you can quickly repay. The last thing that you want is to default on your loan.
Using the formula above, you can understand how much each monthly payment will be. You must know ahead of time whether you can afford payments or not. There are several types of loans and alternative options if you need funding for your business. You can always avoid the loan process and simply bring an additional partner or apply for a line of credit instead.
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