How Business Loans Work: From Application to Repayment

A business loan provides funds to a business entity, such as a company, partnership, or sole proprietorship, to meet financial needs. This debt financing allows businesses to access capital for various purposes, including expanding operations, purchasing assets, or managing cash flow. The borrowed money is repaid over a set period, typically with added interest.

Types of Business Loans

Businesses have access to several types of loans. Term loans provide a lump sum that a business repays in regular installments over a predetermined period. These loans often feature fixed or variable interest rates and are typically used for significant investments like purchasing equipment, acquiring commercial real estate, or funding expansion projects. Term lengths vary, with short-term loans repaid within a year, intermediate-term loans over one to five years, and long-term loans extending from five to ten years or more.

A business line of credit functions similarly to a credit card. It allows a business to borrow funds up to an approved limit, drawing money as needed and paying interest only on the amount utilized. As funds are repaid, they become available for re-borrowing, making lines of credit suitable for managing day-to-day operating expenses or seasonal cash flow fluctuations. Equipment financing is tailored for acquiring physical assets, such as machinery, vehicles, or technology. The purchased equipment typically serves as collateral for the loan.

Commercial real estate loans are for purchasing or remodeling business properties. These loans can have repayment periods extending up to 25 years, with the real estate serving as security for the debt. Small Business Administration (SBA) loans are government-guaranteed loans offered through approved lenders. The government guarantee reduces risk for lenders, often resulting in more favorable terms, such as lower interest rates and longer repayment periods, for eligible businesses.

Eligibility and Lender Requirements

Lenders assess several factors to determine a borrower’s creditworthiness and ability to repay a business loan. A business credit score reflects a company’s financial health and history of managing obligations. A higher business credit score generally leads to more favorable loan terms and lower interest rates, as it signifies reduced risk. Credit bureaus calculate these scores based on factors like payment history and credit utilization.

The personal credit score of the business owner is also evaluated, particularly for smaller businesses or startups. Lenders often look for a personal FICO score of 680 or higher, though some online lenders may have more flexible criteria. This personal financial history helps lenders gauge the owner’s responsibility with debt, directly influencing loan eligibility. Lenders also consider the time a business has been operating, as established businesses are viewed as less risky. While some online lenders may consider businesses with six months in operation, traditional banks often prefer a longer history.

Annual revenue and financial health demonstrate a business’s capacity to repay a loan. Lenders scrutinize financial statements, including income statements and cash flow reports, to verify revenue stability and profitability. Minimum annual revenue requirements vary by lender and loan type, ranging from tens of thousands to over $100,000. Collateral, an asset pledged to secure a loan, provides a safety net in case of default. Common examples include real estate, equipment, inventory, or accounts receivable, and offering collateral can result in lower interest rates due to reduced lender risk. A business plan is also important, especially for new ventures or those seeking funds for expansion, as it outlines the intended use of the loan and projected financial performance.

The Application Process

Securing a business loan involves several steps, beginning with preparation. Businesses should research lenders to identify those offering loan products aligning with their needs and financial profile. Many lenders offer an initial inquiry or pre-qualification stage, allowing businesses to gauge eligibility before a full application. This preliminary step can help streamline the process by identifying suitable options.

Gathering all necessary documentation is a crucial phase. This typically includes financial statements, such as income statements, balance sheets, and cash flow reports. Lenders also request business tax returns, bank statements, a business plan outlining how funds will be used, and legal documents like business licenses and the Employer Identification Number (EIN). Once prepared, the application is submitted, either online or in person, depending on the lender’s procedures.

After submission, the application enters the underwriting phase, where the lender assesses credit risk. Underwriters review all submitted financial information, credit scores (business and personal), and the business’s financial stability to determine its capacity for repayment. This review culminates in an approval or denial decision. If approved, the lender extends a loan offer, which includes the loan amount, interest rate, repayment schedule, and any associated fees. Businesses should review this loan agreement before signing, after which funds are disbursed, typically via electronic transfer to the business’s bank account.

Loan Repayment Structures

Loan repayment involves distinguishing between principal and interest. The principal is the original amount borrowed, while interest is the cost charged by the lender for using those funds. Each loan payment typically consists of both principal and interest, with the proportion of each changing over the loan’s life.

Most business loans are repaid through an amortization schedule, which breaks down fixed payments over the loan term. This schedule details how much of each payment reduces the principal balance and how much covers accrued interest. Commercial real estate loans might amortize over 20 to 30 years, while other business loans may have shorter amortization periods, such as 3 to 10 years. Repayment schedules are commonly set monthly or quarterly, providing a predictable financial obligation.

The loan term defines the total period over which the loan must be repaid. This term can vary significantly, from a few months for short-term financing to over 25 years for long-term investments like commercial mortgages. Businesses may consider early repayment, paying off the loan before its scheduled maturity date. However, some loan agreements include prepayment penalties, which are fees charged by lenders to compensate for lost interest income. These penalties, typically ranging from 1% to 5% of the remaining balance, are often disclosed in the loan agreement.