In 2021, entrepreneurs filed 5.4 million applications to start new businesses, and this trend showed no signs of slowing in 2022. Of course, starting a business requires capital, and even if you have a groundbreaking idea for a new venture, that doesn’t guarantee you’ll get the funding you need.
In this post, we’ll cover the various types of small business loans, their use cases, and how to choose which one is best for your startup or your existing business.
Traditional Small Business Loans
If you’ve ever had a mortgage or a car loan, you’re familiar with how traditional loans work: You apply for a certain amount of funding and a lender evaluates your ability to repay it. If you qualify for the loan, your creditworthiness will affect the interest rate on your loan. Borrowers with poor credit will pay more in interest than borrowers with stellar credit.
Most types of business loans for small business work similarly. You repay your loan amount over time, with an interest rate set by your lender. Business loans can be “secured” just like mortgages or auto loans, which use your car or home as collateral, or they can be “unsecured.” These are the key differences:
- A secured small business loan gives the lender the right to seize and sell the collateral you have pledged if you default on your payments. Collateral may include inventory, accounts receivable, or equipment, for example. A secured loan is less risky for the lender, so they are more likely to offer lower interest rates and more favorable terms.
- An unsecured small business loan does not require collateral in exchange for funding. Since lenders incur more risk with unsecured loans, they tend to charge higher interest rates.
What You Need to Know About Loan Interest Rates
Small business loans may have interest rates that are fixed or variable. Here’s the difference between the two:
- A fixed interest rate loan remains the same throughout the life of your loan. This means business owners can predict exactly what their payments will be and plan accordingly. Fixed rates are usually preferable for business owners with great credit. For owners working on improving their credit, a fixed interest rate may mean being stuck with a high interest rate when their credit improves (or needing to refinance for a lower rate).
- A variable interest rate is somewhat of a gamble, because it’s based on a benchmark interest rate — usually the rate defined by the Federal Open Market Committee (FOMC). If the benchmark rate decreases or increases, so does the interest rate on your loan. The FOMC may adjust rates several times per year, so borrowers might want to avoid variable rate loans unless they can repay them quickly.
Small Business Line of Credit
Like a small business loan, a line of credit may be secured or unsecured. But whereas an installment loan provides a lump sum of cash, a line of credit is funding that is available if and when you need it. If a lender approves you for a $200,000 line of credit, you can draw against that amount as needed and you’re only obligated to repay the amount you use, as well as any interest on that amount.
A business line of credit is best suited to situations in which you need capital to cover variable costs. Seasonality, rapid growth, large customer invoices, and unexpected costs are all good examples of when having a line of credit would be helpful.
Business Credit Card
Many entrepreneurs rely on business credit cards to cover everyday costs like supplies. A business credit card functions like a loan, in that you agree to make minimum payments at a specific interest rate. But depending on how you use the card, you could end up paying a lot more for purchases than you’d planned.
Some credit card companies may charge a low introductory rate that increases dramatically if you don’t pay your balance in full within a certain timeframe. If you’re late with a payment, you’ll likely have to pay a late fee, and the credit card provider may then lower your credit limit and/or increase your interest rate. On the plus side, borrowers with lower credit scores may be able to use timely credit card payments to rebuild their credit.
Convertible Debt
Convertible debt is part investment, part loan. The way it typically works is: An early-stage startup receives a “loan” from an investor that they then repay over time. If it is not paid back in time, the debt converts to equity. Entrepreneurs considering this type of arrangement should consult an attorney, as the terms of these deals can vary considerably.
Applying for Small Business Loans
The application process for all types of small business loans is unique to each lender. Some of these processes are much more stringent than others. For example, if you plan to apply for a U.S. Small Business Association 7(a) loan to cover your working capital needs, you’ll have to complete and provide several documents, including:
- Profit & loss statements
- SBA Forms 1919, 912, and 413
- Projected income statements
- Resumes for each principal partner
- Tax returns
You’ll also need to prove that you’ve sought other means of financing, such as using your personal assets or savings to finance your business. And the SBA may request additional documentation as they assess your need and creditworthiness.
Fortunately, when you apply for small business loans online, the process is often much simpler.
An Easier Way to Support Your Business
Whether you need to cover payroll, purchase inventory, or invest in marketing, Aion can help. We offer flexible financing solutions from $10,000 to $5 million, with a simple portal that lets you access and manage funds right from your smartphone or desktop.
Start growing your business now with Aion. Apply today!