At some point in their career, many entrepreneurs are faced with the question of how to access capital for their business. In other words, how do business loans work?

Ken Alozie thinks about the answer to that question every day. Alozie is a mentor with SCORE, a network of volunteer business experts that provide free small-business mentoring sessions, workshops and educational services to clients across the nation, and is also principal at Greenwood Capital Advisors in Washington, D.C., which provides funding for small- and medium-size businesses.

Alozie believes that all entrepreneurs should have a plan for funding—be it a loan or a line of credit—whether they need it at the moment or not. That way, if they face a financial crunch, they know the steps to take. “Read everything you can and educate yourself on how banking works, how loans work, the types of loans that are out there, just so you're coming in the door a little bit more educated," he says.

To help business owners understand how business loans work, Alozie shared insights on some of the common loans available for small and mid-size businesses.

What are the types of business loans?

A business loan is a loan given for a business purpose. Alozie explains that there are many types of business loans that answer a variety of demands. “It can include needing funds to buy equipment, so if you're a bakery, that can be an oven. It could be to hire employees. It could be to take care of startup costs, marketing, business formation. It could also be to buy a business," he says. The answer to how do business loans work could be as diverse as the expenses of the business owner.

Term Business Loan

A term business loan has a set time for repayment (five years, for example), and a payment schedule. “Term loans tend to be appropriate for companies that are going to use those funds now," says Alozie. Say, for example, a farmer is purchasing heavy machinery and needs to pay for the items right away. A term business loan, which requires some collateral, might be the best fit for him or her, says Alozie. “Because the collateral is there, typically the interest rate is going to be lower than, say, a line of credit." Because of that, for businesses that will use the funds right away, a term loan may make the most sense.

Even if you don't really need it, [a line of credit is] a great way to build business credit and build a relationship with a financial institution so that when you need more capital down the line, now you've got this history.

—Ken Alozie, principal, Greenwood Capital Advisors

How to repay your term business loan: A lender will typically set a monthly payment schedule so that that loan is paid off, with interest, within an established amount of time, known as the “term.”

Short-Term Business Loan

As its name states, the time granted for repaying a short-term business loan is brief, often 30 or 90 days. Because these loans tend to be more costly than traditional financing, Alozie says that this kind of loan is best for businesses that are in a financial crunch—maybe they've exhausted other lines of credit or are unable to access other capital sources. He shares the example of a jeweler who uses a short-term loan to purchase a large order and then turns around and sells that order within the time period of the loan. “It can make sense if the return you expect to make from the loan exceeds the cost of capital," he says.

How to repay your short-term business loan: Short-term business loans are paid back more quickly than other types of loans, usually within 18 months. Depending on the lender and the time granted for repayment, this type of loan could be paid back on a monthly schedule with fees attached; or it could be paid back with interest.

Equipment Financing

Again, this loan is exactly what it sounds like: funding used to pay for the purchase of any type of equipment. That could equipment that is already built—like tractors and buses—or it could be equipment that will be used in the production to create something else, as in manufacturing equipment.

How to repay your equipment financing: The borrower will make set monthly payments that include interest for a fixed term. The equipment itself serves as collateral.

Invoice Financing

When a business has already completed a project but hasn't received payment, they can use their invoice for the project as collateral to borrow money, says Alozie. “It's good for companies that need cash now. They don't want to wait to be paid on that invoice because they have cash needs before that payment date," he explains. He says that this kind of business financing is frequently used by contractors, including government contractors, so that they can cover their expenses quickly, rather than waiting for revenue to come in.

How to repay your invoice financing: A business “sells” its invoices to lender for a set percentage of what they’re worth (say it’s 70 percent). The lender then collects payments from the customers for those invoices. When the money is collected, the lender then gives the remaining 30 percent owed to the borrower. The borrower pays the lender interest or a fee for the service. 

SBA Loans and Grants

The Small Business Association (SBA) doesn't actually make loans, says Alozie. “That's the big misconception here," he says. Rather, he explains, the SBA empowers banks to underwrite loans under a set of guidelines, and if those loans are approved, the SBA will guarantee that loan up to a certain percentage. Alozie says the SBA has two primary products: their “flagship" loan is the SBA 7(a) loan, which can be used for things like working capital or business acquisitions to buy a business or a franchise. The SBA 504 Certified Development Company loan, which promoted economic development, can be used to acquire fixed assets, like real estate, says Alozie. “The advantage of SBA loans are that you can typically get pretty good interest rates, and usually you can get the loan with as little as 10 percent down," says Alozie. The disadvantage, he adds, is that it can take time—sometimes two or three months, depending on the size of the loan. And, also depending on the size of the loan, it may require extensive documentation, including personal tax returns, company tax returns, personal financial statements and more.

In addition, the SBA offers some grants to particular small businesses in areas such as research and development, exporting and other areas.

How to repay your SBA loan or grant: Because SBA loans are guaranteed by the federal agency, lenders are able to offer them with low interest rates and flexible terms. Borrowers pay a monthly fee, which includes interest. The term of the loan depends on what the loan is used for, within the following limits: seven years for daily operations or working capital; 10 years for new equipment purchases; up to 25 years for real estate purchases. Grants, unlike loans, do not have to be repaid.

Business Line of Credit

Similar to a credit card, a line of credit is financing a business owner can draw on, up to a certain amount, and pay interest on the amount used. Say, for example, a business is approved for a line of credit of $200,000. If a business owner finds that he or she needs $10,000 to make payroll, then they can call their financial institution, which will advance that $10,000 to their business bank account. They'll pay interest on that amount as they repay it. Alozie says that he believes all business owners should have access to a line of credit in case of a cash crunch or funding gap. But also, he adds, because it may be helpful in the future in a variety of ways. “Even if you don't really need it, it's a great way to build business credit and build a relationship with a financial institution so that when you need more capital down the line, now you've got this history," he says.

How to repay your business line of credit: With a line of credit, the borrower will make regular payments, along with interest, on the amount borrowed until it is paid off. The borrower can continue to draw more money and make payments until they reach their credit limit.

How to Prepare for a Business Loan Application

In his decades of helping businesses secure capital, Alozie has seen a lot of changes in the business loan world. “It's not as easy as just walking into your local bank anymore. A lot of banks, especially larger ones, they're just not doing as much lending to small businesses," he says.

If you're thinking about getting a business loan or if you're simply wondering how business loans work for your business, Alozie says it's important to know how much of a loan you need and the business purpose of that loan. He adds that it's also important to evaluate yourself as a borrower. Maintain a good credit score, do your taxes properly, and build relationships with a team that can advise you, such as an accountant, an attorney and a banker. That way, if you do one day need a business loan, you'll be ready.

The information contained herein is for generalized informational and educational purposes only and does not constitute investment, financial, tax, legal or other professional advice on any subject matter. THIS IS NOT A SUBSTITUTE FOR PROFESSIONAL BUSINESS ADVICE. Therefore, seek such advice in connection with any specific situation, as necessary. The views and opinions of third parties expressed herein represent the opinion of the author, speaker or participant (as the case may be) and do not necessarily represent the views, opinions and/or judgments of American Express Company or any of its affiliates, subsidiaries or divisions. American Express makes no representation as to, and is not responsible for, the accuracy, timeliness, completeness or reliability of any such opinion, advice or statement made herein.

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