A business loan can supply your business with a capital infusion, smoothing out short-term cash flow problems or providing the necessary working capital to fund a business expansion. Business loan requirements are the criteria you need to meet in order to qualify for various types of financing. Keep reading to learn about the types of business loans available, their requirements and how they can help your business.
What is a business loan?
A business loan is a type of financing that provides a business with working capital to fund expansion or ongoing operations.
There are various types of business loans, such as term loans and start-up loans. Some business loans can be used for general purposes, as in the case of business credit cards, or for carefully defined purposes, as in the case of equipment loans.
Traditionally, the majority of business loans have been disbursed by banks. However, several alternative lending solutions have emerged in recent decades. These lenders cater to businesses that may not meet the criteria for traditional loans.
Who needs business loans from online lenders?
Business loans from online lenders are a good choice if you need money fast or struggle to qualify for financing through a traditional financial institution. This is because online lenders offer fast funding and have more lenient lending criteria than traditional banks.
Many online lenders leverage smart software to streamline their loan approval process and advertise loan approval and fund disbursement within 24 to 48 hours from the initial application.
Online lenders also impose less stringent qualification requirements than many banks. Traditional lenders often require businesses to have been in operation for two years or more and have high annual revenue. In contrast, online lenders often only require businesses to be in operation for six months to a year and generally have much lower revenue requirements.
Note, however, that online lenders typically charge higher interest rates to offset the risk of having more lenient eligibility criteria. So, a traditional bank loan may be a better option if you have an established business and strong credit history.
What are the general requirements for a business loan application?
Every lender has its own set of requirements for business loans. However, most lenders have similar requirements.
Appropriate minimum credit
Lenders typically have a minimum credit score requirement for business loan applications. Your credit score not only affects your odds of approval, but also your loan amount, repayment term and interest rate.
Some lenders check your business’s credit score to determine your eligibility. Unlike personal credit scores, which range from 300 to 850, a business credit score runs from one to 100. You should aim for a score between 80 and 100 to get the best rates.
Some lenders will also look at your personal credit score before coming to a decision — especially if you have a small business, sole proprietorship or startup. tup. In such cases, you might be required to provide a personal guarantee for the loan and demonstrate a history of financial responsibility.
Lenders prefer to do business with profitable companies that have enough cash to meet their loan obligations. Even if a company generates high revenue, low or negative profit margins can make it challenging for them to service their debts.
Additionally, it is common for lenders to require businesses to demonstrate a minimum annual revenue to qualify for a loan. However, specific requirements and thresholds may vary between lenders and loan types.
An established business
Data collected by the Small Business Administration shows that only about half of all small businesses survive for longer than five years. The same data shows that more than 30% of small businesses fail within two years. In light of these statistics, it should be no surprise that lenders prefer to work with established businesses.
Businesses in the early start-up phase are inherently riskier than more mature businesses because they’re more likely to default on their debt obligations. If your business has operated for less than six months to two years, you may have a harder time securing funding. However, time-in-business requirements vary by lender, and alternative lenders generally have more flexible eligibility criteria.
Even if your business is established enough to qualify for loans, you may not qualify for the most competitive rates. Older businesses typically receive more favorable terms, such as lower interest rates and higher credit limits, than younger businesses.
Lenders also look at your debt-to-income (DTI) ratio to determine your loan eligibility. Lenders calculate DTI by dividing recurring monthly debt payments by gross monthly income. For example, if your business has a total monthly debt obligation of $3,000 and a monthly gross income of $10,000 then its DTI will be 30%.
Typically, lenders will not extend credit to businesses with a DTI higher than 43% due to the higher risk of default that comes with servicing a large debt obligation.
Debt service coverage ratio
DSCR is another popular metric used by lenders to determine your business’s creditworthiness. To calculate DSCR, divide net operating income by total debt service. Any number above one signals that a company is bringing in more than enough money to cover its debt obligations.
For example, if a company has a net operating income of $100,000 and a total debt obligation of $90,000, it has a DSCR of 1.1.
However, if the business’s DSCR falls below one, creditors will be less likely to extend a new loan since they're at a higher risk of default. While most lenders who use DSCR require a ratio above one, many place their business startup loan requirements minimum threshold even higher.
Depending on the loan, it may be necessary to provide collateral. Collateral refers to something of value that the lender can seize in case of non-payment. For example, when you take out a car loan, the car acts as collateral. If you stop making your monthly payments on the loan, the lender can repossess your vehicle to satisfy all or a portion of the debt.
In a business context, lenders may ask for equipment, unpaid invoices or even a personal guarantee as collateral for the loan. Note not all lenders and loan types require collateral for credit approval. Lenders generally ask for collateral to offset riskier or more expensive loans.
A solid business plan
Many lenders will require you to submit a business plan as part of a business loan application. Make sure your business plan addresses any questions about how you plan to grow and operate your business, including key elements of your marketing plan and the estimated costs of running your business.
If you haven’t created your business plan or need to touch it up, check out our guide on how to write a business plan.
All required documents
When you apply for a business loan, your lender will require certain documents to verify your identity and assess your business's financial health. While specific requirements may vary by lender and loan type, most will ask for similar documents.
Here are some of the documents most commonly required for a business loan:
- Any applicable business licenses
- Commercial leases
- Balance sheet
- Driver’s license or another form of personal ID
- Articles of Incorporation
- Third-party contracts
- Business plan
- Cash flow estimate and budget
- Bank statements
- Tax returns
- Credit reports
- Financial history statements
- Income statement
A good business credit score
When providing a loan to a small business, most lenders require a personal guarantee from any partner in the business who owns at least 20% of the company.
So, before you apply, make sure to check your personal credit score — either directly with the three credit bureaus or with an independent credit monitoring site like Credit Karma. You should have a credit score of at least 630 to 650 to increase your odds of being approved for financing
In addition to checking personal credit scores, some lenders may also check your business credit score as well. Business credit scores differ from personal credit scores. While personal credit scores range from 300 to 850, business credit scores run from 0 to 100. Most lenders want to see a business credit score between 80 and 100.
What are your options if you have bad or no credit?
Securing a business loan will be more difficult if you have bad or no credit. However, it's not an impossible feat. These are some popular options if you have bad or no credit:
- Net 30 accounts: Net 30 accounts are a common entry point for businesses with no credit history. Certain vendors offer a 30-day interest-free loan on orders. Oftentimes, these vendors will report your payment history to the major business credit bureaus, allowing you to build up a credit score for your business so you can access other forms of financing in the future.
- Invoice factoring: Invoice factoring allows you to sell your business’s unpaid invoices to a third party which then collects payment. Because the invoice factoring company personally collects from the client, it will focus on the client’s creditworthiness and not yours. However, invoice factoring has the potential to damage client relationships, and it will not build your credit score.
- Secured loans: Collateralized loans secure your loan with some form of collateral. We’ll cover this in more depth in the next section, but it's worth noting that many lenders have more relaxed credit score requirements for this loan type.
- Alternative lenders: Large, well-established traditional lenders like Citigroup and Bank of America typically have more stringent lending requirements. Alternative lenders, on the other hand, cater to businesses that can't qualify for traditional loans through more flexible terms and lending requirements. In return, they typically charge higher interest rates and fees.
What is the difference between a secured and unsecured business loan?
The main difference between a secured business loan and an unsecured business loan is that secured loans are backed by collateral and unsecured loans are not. If you default on a secured loan, the lender will take possession of the listed collateral. Collateral can come in many forms including:
- Heavy equipment
- Real estate
- Unpaid Invoices
Some loan types are built with a specific form of collateral in mind. For example, lenders usually have more lenient policies for equipment loans, which are secured by the equipment being financed.
Unsecured loans are not backed by specific collateral. However, that doesn’t mean lenders can’t go after you for any unpaid loan balances. Even though personal guarantees share superficial similarities with secured loans, they’re classified as unsecured loans because the loan is not tied to a specific form of collateral.
When you sign a personal guarantee, you give lenders the right to pursue you personally for the unpaid loan balance if your business defaults on payments, even if your business is organized as an LLC.
Other unsecured loans include business credit cards, business lines of credit and merchant cash advances.
Get a business loan for your business with the right steps
The requirements for getting the best small business loans can be complex. Before applying for a business loan, collect the required documents and information you’ll need to complete the application process. Remember, new business loan requirements may differ from those for a mature business. After you have all the necessary documentation, get in touch with the right lender.
If you have a more established business with a healthy cash flow and don’t need funds quickly, you may be better served by a traditional lender. However, if you need a loan within the next day or two or are in the startup phase of business growth, you may be better off going with an online lender or another type of financing.