What You Need to Know About Small Business Loans

Most people have at least one good business idea in them, but typically don’t turn that idea into a reality. This isn’t because they don’t want to, but rather that a lack of funding makes a business idea just a pipe dream rather than an active plan. In a tight economy, business loans can appear elusive.

We like to believe that hard work is the primary ingredient to success, but hard work alone won’t get your business off the ground. We don’t like to admit, but in order to turn an idea into a reality, you need money.

Why you shouldn’t rely on a traditional bank loan

Once upon a time, banks acted as the engines of local business, lending directly to business owners and helping to develop communities. But since the economic crash of 2008, banks are far more hesitant to loan money directly to small businesses, and for good reason.

According to the Bureau of Labor Statistics, about half of all small businesses don’t make it to five years, while less than a third ever have the chance celebrate a 10th anniversary. Those aren’t great odds if you’re an investor.

Due to the rough track record for new businesses, getting a traditional bank loan to finance your new business is nearly impossible unless you have collateral, such as real estate holdings, to hand over in case you don’t pay the loan back. Even then, your chances of getting a bank to finance your startup costs are still low, especially if your net worth is less than what you’re seeking to borrow. According to a 2016 analysis by Biz2Credit Small Business Lending Index, big banks only approved about 20% of all loan applications, which was actually an increase from the year before. This accounts for an 80% rejection rate.

When starting out, you’ll have to work with a mix of personal savings, independent investors, credit cards, personal loans, crowdfunding, and contributions (gifts or loans) from friends and family. But if you get your business up and running and through the two-year gauntlet, then there are plenty of options to help your business grow after you’ve proven your mettle.

SBA loans to the rescue

So you’ve made it to the two-year mark and it’s time to expand. One of your best tools for expansion is a loan from the Small Business Administration, who offers a variety of business loans tailored for different types of borrowers.

A common misconception is that the Small Business Administration issues the loans themselves. Actually, the SBA helps secure the loans through financial institutions by guaranteeing up to 85% of the loan. Think of the SBA as a good friend who’s willing to vouch for your ability to pay back the loan. But if you can’t pay off the loan, then the SBA is on the hook, so don’t expect another loan if you default.

SBA loan requirements

Before you begin shopping for an SBA loans, you’ll need to know the barriers to entry. Typically, SBA loans require at least a credit score of 600, at least $50,000 in revenue, and your business needs to be in operation for at least 2 years. Your business’ debt to income ratio should also not be above 33%. In other words, for every dollar you borrow, you need to be making $3.

On the SBA website, you’ll find a variety of loans being offered, each with their own standards of necessary paperwork. Be sure to research the credit and collateral requirements for each financial institution to know exactly what you’ll need. Approach it like you would research a used car, considering factors like APR, credit score, and the minimum revenue needed to secure a loan. Be sure to read the requirements before applying or else you’ll spend hours on something that you won’t even be considered for.

Which types of businesses are allowed and which are prohibited?

SBA loans limit their lending to companies that fall under certain specifications, including businesses that:

• Operate for profit
• Are small, as defined by the SBA
• Engage or plan to do business in the US
• Have reasonably invested equity
• Are able to demonstrate a need for the loan
• Have exhausted all other financial routes before seeking out the loan
• Use the funds for a sound business purpose
• Are not delinquent on any existing debt to the US government

As for prohibitions, there are certain types of businesses that are not allowed to receive an SBA loan, including:

• Financial firms involved in lending (although pawn shops may apply in some circumstances)
• Businesses owned by landlords who don’t use or occupy the assets that were acquired or improved by the loan
• Life insurance companies
• Businesses engaged in teaching, counseling, or indoctrinating religion
• Businesses engaged in political activity

You can find a full list of requirements and prohibitions here.

Here’s a guide to the most common types of SBA loans so you can see which one fits you best and what you’ll need to secure funding for your business.

7(a) Loans

With their most popular 7(a) loans, the Small Business Administration helps small business owners secure loans ranging from $5,000 to $5 million, with the average loan amount in 2016 being $375,000. Repayment terms range from 5 to 25 years, based on the amount requested and the borrower’s creditworthiness. Loan recipients pay back the loans with fixed, monthly payments and are subject to additional fees each year.

Interest rates for SBA loans are determined by the prime rate, also known as the base rate, which is typically set by the 25 largest banks and reported by the Wall Street Journal’s bank survey. The current prime rate stands at 4.25%, but this is subject to change.

The SBA then adds a limited markup, called a spread, on top of the prime rate. For loans over $50,000 with a term of 7 years, the maximum spread tops out at 2.25%. This means that your maximum interest rate would be 6.50% (4.25% prime rate plus 2.25%). However, the annual percentage rate (APR) will be higher because this includes all loan fees.

SBA Express Loans

An SBA Express loan allows business owners to borrow up to $350,000 with a shorter turnaround time than a 7(a) loan. With an Express loan, you can gain approval as quick as 36 hours after you apply. You are able to negotiate the interest rate with the lender, but they can’t exceed 6.5% over the base rate for loans of $50,000. For loans over $50,000, the interest rate is capped at 4.5% over the base rate.

The higher interest rates can make an Express loan less attractive to some, but they do offer quicker approval times. For anyone with an Amazon Prime account knows, speed isn’t free, but the extra cost can be worth it.

SBA Community Advantage Business Loans

Community Advantage loans help community-based, mission-focused businesses who operate in underserved areas. These businesses include those run by women and minorities, along with those who operate in rural communities. The federal government kickstarted these loans in 2011, a few years after the recession devastated those particular communities.

Under a Community Advantage business loan, small business owners are able to borrow up to $250,000, regardless of their balance sheet or amount of collateral. Lenders can charge up to 6% above the base rate, which is higher than a typical 7(a) loan. But the repayment terms last from 7 to 10 years, so you’ll have a longer time window to pay it back.

One disadvantage of a Community Advantage business loan is the amount of time required for approval. These business loans need to be underwritten by the lender, then approved by the SBA, which can take several months. Being thorough with your application paperwork and responsive to any requests for additional information can potentially speed up the process.

Requirements will differ based on the lender, but at the least you’ll need:

• Three years of personal tax returns
• Three years of business tax returns (if available)
• SBA-approved Personal Financial Statement (SBA form 413) containing a list of personal assets and liabilities
• Business plan with two years of financial projections (if business is a startup)
• Proof of down payment, which is usually 10-20%, but will depend on lender
• Clean background in regards to past loan defaults, including federally-insured student loans and federally-backed mortgages like FHA or VA loans

SBA Veterans Advantage Business Loans

In 2012, veterans made up about 9% of all business owners in the US, according to census data. Veterans were also more likely to own more than one business than the average American.

To further encourage this natural entrepreneurship, the Small Business Administration secures business loans for veterans, members of the armed forces and their spouses. These business loans are similar to SBA Express and 7(a) loans, but with added perks. The Veterans Advantage program allows borrowers to waive the standard guaranty fee, which is normally 3% of a loan of $150,000 to $300,000. For loans between $300,000 and $500,000, you’ll receive a 50% discount on the guaranty fee.

In order to get these perks, your small business must be at least 51% owned and controlled by a veteran, an active duty military member, reservist, or National Guard member. Spouses of any of any of these groups are also eligible, along with widowed spouses of a service member who died in service or because of a service-related injury or disability. But you’ll have to act fast because the Veterans Advantage program ends on September 30, 2017 if it’s not renewed.

Dot your i’s and cross your t’s

Whichever group of business loans you decide on, be sure to understand all the terms, expectations and requirements associated with the lender. One missing document could mean the difference between starting your business and wasting several hours for nothing.

Also, know your business plan inside out, especially in terms of where the loan funds will go. More than anything, lenders desire confidence that you know what you’re doing and that you’ll effectively allocate their loan. The more questions you can answer, the more likely they’ll approve your loan.