How Do Small Business Loans Work?

“How do small business loans work?” may seem like a simple question with an equally simple answer, but if you’ve ever considered applying for small business funding, you know that small business loans are far from straightforward. Each type of small business loan works differently and the requirements vary greatly by lender. Understanding how they all work and which loan type or lender is a good fit for your business can be exhausting.

Don’t be discouraged! The specifics may differ significantly, but there are commonalities between loan and lender types. To help you understand the essential components of small business funding, this guide will provide some general advice and information about how small business loans work, including:

• The basics principles of how small business funding works
• Different types of lenders
• Summary of different types of small business loans
• Repayment options

Let’s get started.

Here’s some good news: You’re probably already familiar with the basic principles of how small business funding works. Here’s a quick overview:

1. Business loans are offered by lenders. There are multiple types of lenders, including traditional lenders like banks and credit unions, as well as SBA-backed loans and alternative online lenders like Greenbox Capital®. Different lenders have different application requirements—read more about that in our guide to small business loan requirements.
2. If your application is approved, the lender will supply the funding you need, plus interest or a factor rate, as well as other fees. The terms of your funding will depend on the specific type of funding you receive.
3. You pay back the funding over a set amount of time, with regular payments determined in advance by you and your lender.

The exact structure of your loan, including repayment terms and fees, depends on the type of loan you receive, as well as the type of lender you’re working with.

We’ll explore each of these basic principles in detail throughout this guide.

Traditional lenders such as banks and credit unions offer a variety of lending options, including:

• Term loans
• Lines of credit
• Real estate loans
• Equipment financing

These lenders tend to approve only well-established businesses with strong financial histories seeking loans for larger amounts. The application process is lengthy and intrusive, and most applicants are rejected, especially for newer businesses or smaller loan amounts that will generate less profit for the lender.

SBA- or BDC-backed loans are supplied by intermediary lenders, but are guaranteed up to 80% by the SBA (or BDC in Canada). This reduces the risk to the lender and encourages them to grant more loans.

These loans typically carry the best terms with lower fees, but the application process is very difficult and lengthy, and the vast majority of applicants are rejected.

Also referred to as online lenders or direct lenders, alternative lenders offer funding supported by new technology and online platforms that streamline the application and underwriting process. These lenders offer a variety of funding options, often for shorter terms and smaller amounts. Rates are typically higher, but application requirements are also easier and more flexible with faster approval.

Alternative lenders are an ideal choice for businesses who are unable to acquire funding from traditional lenders, such as newer businesses, businesses with lower credit, or businesses who need working capital quickly. However, not all alternative lenders are created equal—make sure you thoroughly screen your funding partner, and only work with lenders who provide responsible funding.

There are many different types of small business loans available to business owners, each with their own qualification requirements, rates, and terms.

The type of funding that works best for your business will depend on a number of factors, including your intended purpose, your business’s history and earning potential, and the type of lender you apply for funding from.

Here’s a summary of 10 of the most common types of small business loans:

For detailed information about the different types of small business loans, including rates and terms, application information, and who should apply, check out our guide to 10 Common Types of Small Business Loans.

Your repayment terms will depend on the type of loan you receive. There are three primary repayment structures for paying back your small business funding:

With revolving funds, you are granted a credit line that you can access and repay as needed. As long as the account is open, you can draw and repay up to your maximum credit limit multiple times. The most common example of revolving funding is a business credit card or some business lines of credit.

With installment funding, you’ll receive the full amount of your loan up front and will pay it back in equal installments according to a schedule you set up with your lender, typically with fixed monthly payments. The most common example of installment funding is a traditional term loan.

You’ll receive the full amount of your loan up front, but repayment will be based on your cash flow rather than a set payment or term length. When repaying a merchant cash advance, for example, your lender will automatically deduct a percentage of your daily or weekly credit and debit sales until the advance is repaid. The most common examples of non-loan cash flow funding are merchant cash advances or invoice factoring.

Learn More About Merchant Cash Advances

There is no easy answer to the question “how do small business loans work?”. Each type of loan works differently, with varying requirements, qualification criteria, and terms. Lenders work differently as well, adding up to one complicated lending landscape that can discourage even the most entrepreneurial small business owner.