Introduction to Small Business Loans
Small Business Loans, Explained.
by Joyce Chen
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Navigating the world of small business loans for the first time can be daunting, so we’ve put together this comprehensive guide to help you find your footing. For more personalized advice, try chatting with Haystack!
Why Take Out a Loan
Small businesses may take out loans for a variety of reasons, depending on their stage of growth, financial needs, and strategic goals. Here are some common reasons why a small business might seek a loan:
Managing Cash Flow
- Why: Cash flow issues are one of the most common challenges small businesses face, especially during seasonal lulls or when waiting for payment from clients.
- How a Loan Helps: A short-term loan or line of credit can provide the cash needed to cover operational expenses like payroll, rent, and utilities until revenue is stabilized.
Business Expansion
- Why: As businesses grow, they often need more space, employees, or equipment. Expansion might also include opening a new location or increasing product lines.
- How a Loan Helps: A loan provides the necessary capital to fund these growth activities without the business having to dip into its cash reserves.
Purchasing Equipment or Inventory
- Why: New or upgraded equipment and inventory are essential for businesses in industries like manufacturing, construction, and retail.
- How a Loan Helps: Equipment financing or a business loan can be used to purchase or lease expensive machinery or buy bulk inventory upfront to meet demand.
Starting a New Business
- Why: Entrepreneurs often need capital to cover startup costs, which can include everything from legal fees to initial marketing, hiring staff, or securing a location.
- How a Loan Helps: Small business startup loans, including microloans, can provide the early-stage capital to get a new business off the ground.
Refinancing or Consolidating Debt
- Why: Businesses with multiple high-interest debts might want to consolidate these debts into a single, more manageable payment with lower interest rates.
- How a Loan Helps: A business loan can be used to refinance or consolidate high-interest debts into one loan, potentially saving the business money on interest and improving cash flow
Hiring Employees or Expanding Payroll
- Why: Growing businesses may need to hire additional staff or temporarily cover payroll during slow revenue periods.
- How a Loan Helps: Loans can ensure that businesses have the necessary funds to meet payroll obligations while revenue catches up, especially during times of growth or seasonal demand.
Covering Unexpected Expenses
- Why: Unforeseen expenses such as equipment breakdowns, natural disasters, or sudden market changes can disrupt a business’s financial health.
- How a Loan Helps: Emergency or short-term loans can help businesses weather financial shocks by providing quick access to capital when unexpected costs arise.
Investing in Marketing or Technology
- Why: Marketing campaigns and tech upgrades (e.g., a new website, CRM systems, or software) can help businesses attract new customers and streamline operations.
- How a Loan Helps: Loans provide the funds necessary for these investments, allowing businesses to grow and compete more effectively.
Meeting Regulatory or Compliance Requirements
- Why: Certain industries have to meet specific legal or compliance requirements that could necessitate additional investment, such as safety upgrades, certifications, or licenses.
- How a Loan Helps: A loan can cover these often-unplanned costs without burdening the business’s cash reserves.
Terminology
As you begin researching the best loan for your small business, you might run into some new terminology.
Principal:
- Definition: The original amount of money borrowed or the remaining balance of the loan.
- Example: If you take out a loan for $50,000, the principal is $50,000 until you begin paying it down.
Amortization:
- Definition: The process of spreading loan payments over a fixed schedule, typically with a portion going toward interest and the remainder paying down the principal.
- Example: In a fully amortizing loan, each payment gradually reduces the loan balance.
Collateral:
- Definition: An asset that the lender can seize if you default on the loan. Collateral is often required for secured loans.
- Example: If you use equipment as collateral and fail to repay the loan, the lender can seize that equipment.
Personal Guarantee:
- Definition: A promise that the business owner will repay the loan personally if the business cannot.
- Why It Matters: It puts the owner’s personal assets, such as their house or savings, at risk if the loan isn’t repaid.
- Example: Many small business loans, especially from online lenders, require a personal guarantee from any business owner with a stake of 20% or more.
Common Fees and Costs
When taking out a small business loan from an online lender, several fees may come into play. Understanding these fees for evaluating the true cost of borrowing. Here’s an explanation of some common fees you might encounter:
Origination Fees:
- Definition: A fee charged by the lender for processing the loan. It is typically a percentage of the total loan amount.
- Amount: Usually ranges from 1% to 8% of the loan amount.
- When It’s Applied: It is usually deducted from the loan amount upfront.
- Example: If you take out a $100,000 loan with a 3% origination fee, you’ll receive $97,000, and $3,000 will go to the lender as the fee.
APR (Annual Percentage Rate):
- Definition: A measure of the cost of the loan, expressed as an annual rate, including both the interest rate and additional fees (like origination fees).
- Why It Matters: The APR provides a comprehensive view of the true cost of borrowing.
- Example: If a loan has a 10% APR, that’s what you’ll effectively be paying over the year, including fees and interest.
Interest Rates:
- Definition: The rate charged by the lender for borrowing money, expressed as a percentage of the principal loan amount.
- Fixed Interest Rates: Stay the same throughout the life of the loan.
- Variable Interest Rates: Fluctuate based on market conditions, which can make monthly payments unpredictable.
- Example: If you borrow $50,000 with a 12% fixed interest rate, you’ll pay $6,000 in interest annually if the loan is unpaid throughout the year.
Prepayment Penalties:
- Definition: A fee charged if you pay off your loan earlier than the agreed-upon term.
- Why It Exists: Some lenders impose prepayment penalties because early repayment means they earn less interest over the life of the loan.
- Example: If a loan has a prepayment penalty of 2%, and you decide to repay a $50,000 loan early, you may have to pay $1,000 in penalties.
*Note: Many online lenders, like OnDeck and BlueVine, do not charge prepayment penalties, which is a significant advantage.
Draw Fees (for Lines of Credit):
- Definition: A fee charged each time you withdraw money from a line of credit.
- Amount: Typically around 1% to 3% of the amount drawn.
- Example: If you have a $100,000 line of credit and withdraw $10,000 with a 2% draw fee, you’ll pay an additional $200.
Late Payment Fees:
- Definition: A fee charged if you miss a scheduled payment.
- Amount: Typically a flat fee or a percentage of the missed payment, such as 5% of the overdue amount.
- Example: If your payment is $1,000 and you miss it, you could incur a $50 late fee (5%).
Maintenance Fees:
- Definition: A recurring fee some lenders charge for managing the loan or credit line.
- Example: Some lenders may charge a small monthly fee to keep your credit line open, such as $10 per month.
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