I’m convinced there are more financing options available for the average small business today than there has ever been—at least since I was a small business owner, nearly 20 years ago. The challenge is determining which options make sense on a financial level as well as a practical level.
Because there is no one-size-fits-all small business loan, there are a handful of questions you need to ask yourself before you start looking for a lender and a loan. The answers to these questions will help you determine the type of financing that will work for your business, and business need.
This is the first and one of the most important questions you need to ask yourself. You loan purpose is important because it will help you identify the type of financing that makes sense for you and will help you answer the other questions. And, in much the same way most of us wouldn’t take out a 30-year mortgage on a new automobile, or expect to pay off the purchase of a new home with a 36-month loan, some business use cases might be better suited to one loan term over others.
For example, borrowing to purchase quick-turnaround inventory (that will likely be sold within a month or two), will likely require a different type of financing than borrowing to purchase a new warehouse, opening a new location across town, or purchasing some kind of industrial machinery. When you can clearly articulate your loan purpose, it’s much easier to determine the loan term that makes the most sense. Should you be applying for a short-term loan, borrowing for three to six months, or a long-term loan such as 10 years, or some other term in between?
If your answer was, “How much can get?” I don’t think that’s the right answer.
First, there are expenses associated with borrowing, regardless of the lender you choose. So borrowing more than is required to meet your business need can be too expensive—and might even have negative consequences. Borrowing only what is required is a better strategy. So, in other words, in addition to identifying your loan purpose, you should also identify what amount of capital will be required to meet that purpose.
Secondly, some lenders prefer to lend larger amounts to established businesses, while others specialize in very small, or micro loans. There are exceptions to this example, but typically the local bank would prefer to lend $1 million or more, rather than $10 or $20 thousand. For them, the costs to process and underwrite the loans are similar, so it’s hard to blame them. On the other hand, there are micro-lenders who work with very small, or underserved businesses, and specialize in loans of $5,000 to $10,000.
Knowing the loan amount, you’re looking for will help you determine where to look.
My personal opinions are pretty conservative in this regard; and shaped as a young man working in my father’s business. He was of the opinion that if borrowing capital didn’t either add value to the business or increase ROI in some way, he didn’t borrow.
Leveraging borrowed capital to make additional profits is a good reason to take on the expense of a small business loan—but that’s not to imply that borrowing for other reasons are inappropriate. If there is no expected ROI, the decision to borrow should be made more cautiously and more deliberately because the loan and the periodic payments will become an overhead expense that doesn’t generate any additional revenue.
For most small business owners, your personal credit score is going to be part of the equation when they evaluate your creditworthiness. That being said, even if your personal credit score is less than perfect, there are still options for your business. Nevertheless, you should be aware that depending upon the lender, there are credit thresholds they typically won’t drop below. For example, the bank is looking for borrowers with a personal credit score in the 700s (although they will sometimes go as low as 680) and the Small Business Administration (SBA) will sometimes lend to a borrower with a personal credit score of 650. Yet, there are other options if your credit score is 500 or better, but the cost of financing will likely be higher.
You should also be aware that there is often a relationship between the accessibility of financing and the costs associated with borrowing. It’s not necessarily that the better your credit profile the lower the interest rate you’ll pay (although that is sometimes the case), but the stronger your credit profile, the more options will be available to you and you’ll be more likely to have a broader choice of financing options.
Speed to funding can sometimes be a consideration when evaluating your loan options. An SBA loan will likely have some of the lowest available interest rates, but can take weeks, or sometimes even months, to navigate the application, approval, and funding process. This could still be a good option for those businesses that qualify and have the luxury of time to wait, but could make it difficult to respond quickly to an opportunity to purchase inventory at a steep discount, make emergency repairs to business-critical equipment, or meet some other unexpected need—even if it is an opportunity to make extra profits.
Online lenders can often provide an answer to a loan application in a matter of an hour or so, and once approved, can have funds deposited in a business banking account in a day or two. This enables small businesses to respond quickly to emergent opportunities or challenges that the bank or the SBA can’t accommodate.
Which financing option is a good choice to meet your business need? There is likely more than one. Answering these five questions will help you determine what you should be looking for and where you should look.
By Ty Kiisel:
Ty Kiisel writes about small business and small business finance as Editor for OnDeck. With over 30 years in the trenches of small business, I’m a Main Street business evangelist, author, and marketing veteran that makes the maze of small business lending accessible by weaving personal experiences and other anecdotes into a regular discussion of one of the biggest challenges facing small business owners today.