How Do Small Business Loans Work? Process, Loan Types & Eligibility
In 2024, 59% of small businesses applied for financing, with 50% applying for loans. The main reason was to pay for their operating expenses, which 56% cited as a financial challenge. These numbers show that for entrepreneurs, small business loans are often a crucial lifeline.
However, securing funding for your business can sometimes feel like an uphill climb. Faced with complicated application processes and paperwork, you’re left wondering, “How do small business loans work?”
In this article, you’ll learn more about applying for small business loans, including:
The basic loan processes
The common types of small business loans
Their eligibility requirements
Alternative small business financing to consider
How Do Small Business Loans Work?
Small business loans are generally term loans with interest rates and repayment terms. The requirements, loan agreements, and application timelines depend on the lender, but below are the main processes for getting a loan.
Application
This stage involves gathering the lender’s required documents and filling out the application forms. Once you’re ready, you can submit your application either in person or online.
Many lenders, even banks, allow you to apply through their websites. However, applying in person has some perks, especially if you’re already a bank customer. For example, you may be able to lower the interest rate or credit score requirement if you already have a good relationship with your bank. Loan officers may also offer you fee discounts as part of their member benefits.
Once you’ve submitted your application, the lender may reach out to you with questions or for additional documents based on your industry or business type.
Underwriting
The lender then reviews your application to assess your creditworthiness and default risk. Depending on the loan program, the lender may consider your collateral details, credit history, credit score, and financial performance when making their assessment.
Traditional financial institutions, like banks, are risk-averse, meaning they approve borrowers with the lowest risk of defaulting. This is why their underwriting process is strict and may take weeks or even months. It’s also at this stage that the lender determines your loan and repayment terms, such as the loan amount, fees, down payment, interest rate, and length of the loan.
Funding and Repayment Period
Once your application is approved, the lender will deposit the funds as a lump sum into your business bank account. After receiving the funds, you will start your repayments, which are typically fixed monthly payments.
If you miss a payment, most lenders have a grace period. However, the grace period may come with late fees and a late payment mark on your credit report. If you’re still unable to pay beyond the grace period and go into default, the lender may seize your collateral (for secured loans) or take legal action.
3 Common Types of Small Business Loans
Now that you know how small business loans work, let’s take a look at the different loan types available. These loans can be used to manage daily operations or invest in growth, and are either secured or unsecured. Secured loans require collateral, while unsecured loans don’t.
While there are several loan programs available for small businesses, below are the main loan options and providers.
1. Term Loans
Term loans are the most common type of small business loans. They can be short-term or long-term and are available from banks, credit unions, and online lenders.
Short-term loans typically have a repayment period of up to 18 months. They’re often used to optimize working capital and cash flow.
Meanwhile, long-term loans have a repayment period of up to 25 years. They’re typically used for more expensive investments, such as buying commercial real estate. As such, they often have higher loan amounts and require collateral or a personal guarantee.
2. SBA Loans
The U.S. Small Business Administration partners with approved lenders to offer SBA loans. The government partially backs these loans, meaning the SBA will pay the lenders if the borrower defaults.
SBA loans have some of the most competitive terms out there, including lower credit score requirements and fixed interest rates. In particular, the SBA 7(a) Loan can be used for any business need, such as boosting working capital, buying new real estate and equipment, and refinancing business debt.
3. Microloans
A favorite of startups and new businesses, microloans usually offer up to $50,000 in funding. These loans are generally available from alternative and nonprofit lenders as well as government agencies, like the SBA.
Funds from microloans may have restrictions on how they can be used. For example, you may be unable to use the money to pay other debts or buy real estate.
Because the goal is to encourage the growth of new businesses, nonprofit microloan providers may waive application fees or interest rates. Some lenders may even accept low or even bad credit.
Eligibility Requirements for Small Business Loans
Loan application requirements can depend on the lender and the loan program, but below are some of the most common requirements:
Business details, particularly how long you’ve been operating
Financial statements (e.g., income statement, balance sheet, and cash flow statement)
Tax returns
Business plan
Credit history
Personal and business credit score
Proof of collateral or personal guarantee
High annual revenue and collateral value plus good credit increase your chances of getting approved. You may also get more competitive terms, such as lower interest rates, higher loan amounts, or more flexible payment schedules.
What Other Small Business Financing Options Are Available?
Bank term loan applications can be long and complicated, which means it takes longer to receive the funding you need. As such, alternative lenders have stepped up to offer more accessible financing options.
These options are often more flexible and convenient, especially if you need the money immediately. That said, they may have higher costs than traditional small business loans.
Below are some examples of alternative financing options.
Business Line of Credit
Similar to business credit cards, business lines of credit are revolving funds you can draw from at any time and for any purpose. You only pay interest on the amount of money you withdraw. Once you repay, that amount is once again available for you to use.
A business line of credit generally has higher credit limits, affordable interest rates, flexible payment schedules, and fewer application requirements. That said, these features still depend on the lender. For example, online lenders may have faster application processes but higher interest rates than banks.
This financing is also often collateral-free. As such, lenders focus on your financial performance, particularly your annual revenue.
Working Capital Advance
This funding is a lump sum given to businesses in advance to help manage daily operational expenses. For example, it can be used for rent, wages, and bulk inventory purchases.
The amount is typically based on the business's cash flow, revenue, and creditworthiness. While it’s generally collateral-free, some lenders may require collateral like accounts receivable, especially for higher loan amounts.
Working capital advances are a good option for businesses that experience fluctuating revenue or those planning to make more expensive investments, such as equipment upgrades. This financing also offers flexible payment schedules, such as daily or weekly instead of monthly.
Invoice Factoring
With invoice factoring or financing, you sell your accounts receivable (unpaid invoices) to a factoring company in exchange for a percentage of the invoices’ value. This percentage is given to you as a lump sum upfront.
The factoring company then collects the payments from your customers. Once they’ve collected the payments, they will pay you the remaining value of the invoices minus their fees.
Because this financing is a sale and not a loan, it doesn’t affect your credit score. That said, it also won’t help you build your credit history.
Get Small Business Financing With Backd
Small business funding can help you sustain your business operations or implement growth strategies. Now that you understand how small business loans work, it’s worth considering alternative financing options that may be more flexible, convenient, and accessible for your needs.
For example, Backd’s Business Line of Credit provides up to $750,000 in funding that can be used for any purpose. Meanwhile, our Working Capital Advance offers up to $2 million, which can be paid daily, weekly, or semi-monthly.
You can easily submit your application through our website and receive a funding offer within as little as 6 hours.
Our eligibility requirements include:
$100,000 in monthly revenue
A credit score of 650+
Established business credit
Based in the U.S. with a brick-and-mortar address
Been in business for one year for a Working Capital Advance and two years for a Business Line of Credit
Apply now to get the small business financing that works on your terms.
