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Choose the right loan for your business using smart financing strategies.

What to Look For (and look out for) in a Small Business Loan

Businesses need money to grow, but it’s not easy to get business financing. Whether you’re just starting a business or already running a business, many entrepreneurs find the task of securing equity and debt financing daunting, and don’t know where to begin. Our tips below will help you assess your business loan options and avoid overpaying.

Get the right financing for your business needs

Business financing isn’t one size fits all. The purpose of your loan has a big impact on what kind of loan product you need and on what loans you qualify for. Here are some guidelines:

Purpose of loan Financing products to try
Gain capital for a new business or acquiring a business SBA 7(a) loan or personal sources of money like home equity, retirement funds, etc.
Buy inventory Inventory line of credit
Buy equipment Equipment lease
Buy real estate SBA 504 loan or bank loan
Cover gaps in cash flow Invoice factoring or business line of credit
Acquire general working capital (e.g., business renovation, expansion, hiring, etc.) SBA 7(a) loan, bank term loan, or online working capital loan

The type of financing you choose makes a cost difference. For example, if you want to purchase equipment for your business, you will save money by getting a low-rate equipment lease that’s collateralized by the equipment, as opposed to a general purpose working capital loan.

Your use of the loan proceeds isn’t the only factor to consider. Things like credit score and business revenues also affect your small business financing options. For example, you can’t get an SBA loan or bank loan without good credit. In that case, you may have to opt for an online working capital loan, which is open to borrowers with lower credit scores. Consider all business loan information before you make the leap. Follow these business loan tips to increase your odds of securing a loan.

Understand the cost of a loan

Once you’ve narrowed down the type of loan you need, you should assess its cost. Ask the lender you’re working with the following questions:

  • How are you measuring the cost of this loan?
  • What’s the effective Annual Percentage Rate (APR) of this loan?

Lenders measure the cost of business financing in different ways, which may or may not take fees and compound interest (interest charged on interest) into account. This is especially true on short-term loans and online loans. Typically, online lenders will tell you the dollar cost of a loan, but won’t disclose the APR.

You should never commit to a loan without getting the effective APR. The effective APR takes fees and compound interest into account and tells you the annual cost of a loan. Having the effective APR allows you to compare different loan products on an annual cost basis.

Watch out for fees and prepayment penalties

Fees and prepayment penalties can be a trap for unwary borrowers.

Fees

Here are some fees that may be tacked onto a loan:

  • Origination fees are taken out of the loan before it is disbursed to you
  • Application fees are for processing your loan application
  • Transaction fees are typically charged each time you draw on a line of credit
  • Inactivity fees  may be charged if you don’t use a loan or line of credit for a certain period of time
  • SBA fees are charged by the government on some SBA loans
  • Referral and packaging fees are charged by lenders for putting together a loan package

Prepayment penalties

Prepayment penalties are fees that a lender charges the borrower for paying off a loan too early. Prepayment penalties can significantly increase the cost of financing, so you should be aware of these before committing to a loan.

Early payment penalties are calculated by multiplying your outstanding loan balance by a percentage, typically 1-3%. Prepayment penalties may also fall on a sliding scale, where you are charged more for earlier prepayments and less for prepayments made closer to the loan’s maturity date.

Know what assets are at stake

Most business loans are secured by business or personal assets. This can take the form of specific collateral that you pledge when getting the loan. A loan can also be secured through a general lien that the lender places on your business assets.

Whether you’ve put up specific collateral or you are subject to a lien, the effect is basically the same. If you can’t pay back the loan, the lender can repossess and sell off your assets to satisfy the loan. You should be especially careful about pledging personal assets, such as a home or car, because you stand to lose them if your business goes south.

Liens and collateral can also affect your ability to get additional financing. Lenders want to be sure that they will be compensated if you cannot pay back a loan. If you’ve already pledged your business equipment as collateral to one lender, you cannot pledge the same equipment as collateral for a second loan.

Bottom line

Getting financing for your business can feel intimidating. By considering your business goals and learning about cost and collateral, you can help yourself get the best financing for your business. For a visual comparison of financing options, you can check out this table on the different types of business loans.

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