Whether you’re facing an emergency or have been planning to make a big purchase like commercial real estate, there comes a time when every business owner needs a loan. If youâve reached this point in your entrepreneurial journey, itâs easy to feel overwhelmed. With so many lenders out there, how do you choose? Which loan best fits your needs â and which is the most affordable? What if youâre facing challenges such as a low personal credit score or youâre a brand new business?
Blindly applying for a loan can make the process daunting and confusing. However, by knowing what to expect (and what to avoid), youâll be cruising through the process in no time. Get on your way to receiving the money your business needs. Read on for everything you need to know before applying for a business loan for the first time.
Before You Apply For Business Loans
Getting a business loan doesnât start with filling out the loan application. Instead, the process should begin before you even talk to a lender. Before you hop online to fill out your application or head to your local bank branch, prepare ahead of time by taking the following steps:
Look Up Your Credit Score
Lenders want to make sure theyâre working with low-risk borrowers who will pay their loans as scheduled. To assess risk, lenders look at a number of factors, including credit scores. Your credit score is one of the most important factors lenders consider when deciding whether to approve your loan application.
A low credit score indicates that a borrower is high-risk. If your credit score is too low, a lender may outright deny the loan application. In other cases, loan options may be available but at a higher price for the borrowerÂ — think higher APRs, down payment requirements, and the need for collateral.
Instead of allowing your credit score to creep up and startle you during the loan process, know where you stand before you even apply for a business loan. The internet makes it easier than ever to get your credit score, and best of all, many sites allow you to view your score for free.
To receive the best loan offers, a score that is at least in the high 600s is required for many business loans, including loans from the Small Business Administration and banks. However, some alternative lenders will give loans to borrowers with scores as low as 500. A lower score may result in fewer options and higher costs over the life of the loan in most cases.
If your credit score is very low, you may choose to work on raising this score before applying for a loan. You can do this by reviewing your credit report, disputing any erroneous items, working to pay down outstanding debt, and always making your payments on time. If a loan is needed immediately and you donât have time to boost your credit score, weigh out the costs of any loan offer provided to you. If you accept, make all payments on time as scheduled in order to help build your score to qualify for more options in the future.
Decide Why You Want The Loan & How Much You Need
Before taking on the debt of a loan, itâs important to establish why you need the loan. Itâs easy to just grab for the money right in front of you, but you need to determine whether your reasons for taking the loan are sound.
Before applying for a loan, consider your return on investment. In other words, will taking out a loan and paying fees and interest be worth it? If the loan will benefit your business and outweigh the costs, proceed with the loan process. If there is no real benefit to receiving a loan, reconsider taking on this extra debt.
Youâll also need to decide how much money you need. Once youâve determined how youâre going to spend the loan proceeds, this step shouldnât be too difficult. If youâre buying a new piece of equipment, shop around to get price estimates. If youâre updating your facilities, get bids from vendors and contractors. If your goal is to purchase commercial real estate, look at comparable commercial properties in your area to get an idea of what youâll spend.
Not only will knowing 1) why you want the money and 2) how youâre going to spend it help with your own planning, but lenders will need this information to determine if you qualify for one of their loans.
Calculate How Much You Can Borrow
You know how much you need to borrow. Now, you need to calculate how much you can afford to borrow.
Before applying for a loan and taking on debt, youâll want to calculate your debt service coverage ratio or DSCR. This shows the relationship between the income and debt of your business.
Debt Service Coverage Ratio = Net Operating Income / Debt Obligations
To calculate DSCR, divide your net operating income by your debt obligations for the current year. Your net operating income will include all revenue minus operating expenses. Your debt obligations will include all debt, including interest and fees, for the next year.
After plugging your numbers into the formula, your DSCR should be at least 1.25. This shows you (and your lender) that you are bringing in enough income to cover your current debts and can take on additional debt, such as a business loan.
Letâs say that your business brings in $150,000 in net operating income. You have $110,000 in debt obligations for the current year. Plugging these numbers into the equation results in a DSCR of 1.36.
Now that you know that you can afford a loan, the next step is to calculate your borrowing amount. You can do this by dividing your net operating income by 1.25. Once you have your answer, subtract your current debt obligations from this number. This will provide you with the amount of additional debt you can take on.
This may seem confusing, so letâs take a look at the example from earlier. Your net operating income is $150,000. Divide this number by 1.25. This results in a total borrowing amount of $120,000. However, you already have $110,000 in debt obligations. Simply subtract this from the total borrowing amount, and the result is $10,000. This means that you can borrow a maximum of $10,000.
Not only will this help with your own budgeting purposes, but these numbers are used by lenders to determine if you will be able to afford the loan you are requesting. Read on to learn more about calculating how much you can borrow.
Bolster Your Online Presence
Lenders want to loan money to borrowers that are low-risk and will pay their loans back as agreed. This is why the loan process can be so tedious. Lenders evaluate your credit score, your business revenues, and â¦ your social media?
Believe it or not, many lenders are now turning to the internet to learn more about loan applicants, especially small business owners. In fact, itâs been reported in the past that FICO is considering using social media as one of the factors to measure creditworthiness.
Before applying for a loan, consider bolstering your online presence. Make sure that any online resumes are completed updated. Reach out to your clients and customers and encourage them to review and rank your business through social media and review sites like Yelp For Business. You want to show lenders that you are a trusted, well-established business.
Itâs also important to never complain about work or discuss financial challenges online. This doesnât just look negative to lenders, but itâs a general best practice that will help you maintain a veneer of professionalism to your customers, clients, and anyone that searches for you or your business online.
Prepare Your Documents
Thereâs one thing that can never be avoided when applying for a loan: submitting your paperwork. Although requirements vary by lender, the amount of money youâre requesting, and the type of loan youâre applying for, there are a few basic documents you will need to prepare ahead of time to submit with your application.
For most loans, you will need to show your most recent income tax returns. Prepare a minimum of 2 yearsâ worth of returns to submit with your application. You may also be required to show bank statements. Although as few as three may be needed, plan ahead by having at least the last 6 or 12 monthsâ worth of business bank statements.
Additional documentation surrounding income and revenue may also be required. This includes profit and loss statements and balance sheets.
For many loans, youâll also need to prove that you are the owner of the business. This can be done with business licenses, certifications, and other documents.
If you are purchasing real estate, a purchase agreement may be required. If youâre using the loan to refinance existing debt, youâll need information related to your debt, including but not limited to account numbers and statements.
Clearly, if youâre a new business or startup, you may not have access to many of these documents. Instead, youâll need to have a solid, detailed business plan as well as future income projections. You may be required to prove experience in the industry, so you will need to submit your resume with your application, as well as the resumes of any other owners of the business.
You should also know that going into the loan, collateral may be required. Collateral requirements vary by lender, and in some cases, specific collateral is not needed. However, most loans do require a personal guarantee to be signed by every owner of the business. This guarantee holds business owners personally liable for the loan and allows the lender to pursue legal action and even seize personal property if the loan goes into default.
How To Find the Right Lender
Youâve determined why you need a loan. Youâve figured out how much money you need, and this amount aligns with your calculations of how much you can borrow. Youâve gathered your paperwork, and now youâre one step closer to applying for a loan.
However, there are so many lending options out there, where do you even begin? The lender you use depends on various factors, including the amount of the loan, the type of the loan, your creditworthiness, and your time in business. Most business owners turn to three main types of lenders for their business loan needs: banks, the Small Business Administration, and alternative lenders.
When You Should Apply For A Bank Loan
When they need a business loan, many business owners turn to a source they already use for other financial purposes: the bank. Bank loans are popular with business owners because they have extremely low interest rates and excellent repayment terms. Banks offer some of the most affordable loan options on the market.
Banks can also provide high loan amounts, ideal for large expenses like acquiring a business, purchasing a franchise, buying real estate, or improving facilities.
Bank loans are best for applicants with strong credit histories. A credit score in the high 600s and sometimes even at least 700 is needed to qualify for these loans. There should be no bankruptcies, foreclosures, or other major negative items on an applicantâs credit report.
Banks also have extensive paperwork requirements, and collateral is typically required for larger loans. The loan process from banks can potentially take months from start to finish, so business owners with immediate loan needs should seek other lenders.
When You Should Apply For An SBA Loan
Small Business Administration loans are extremely competitive because of their low rates and flexible terms. Because these loans are backed by the government, lenders known as intermediaries have more incentive to loan to small businesses that have trouble qualifying for conventional loans.
The SBA has many loan programs available for business owners. This includes the 7(a) program, which provides up to $5 million for almost any purpose. The 504 program is best for the purchase or improvements of real estate. Microloans are smaller loans of $50,000 or less that are a great choice for startups and businesses that donât require a large amount of capital. The SBA also has the Veterans Advantage program for military veterans and service members, as well as the Community Advantage program for businesses in underserved areas.
SBA loans require a strong credit history with no previous defaults on government loans, foreclosures, or bankruptcies. Credit scores should be in the high 600s to qualify. For higher loan amounts, collateral is required. Startups may qualify for some programs. Applicants must also fall under the SBAâs definition of a small business, which limits the number of employees, annual revenue, and the companyâs net worth.
Because there are so many different programs available through the SBA, these loans are great for just about any business expense. Qualified business owners can apply for these loans through SBA-approved banks, credit unions, non-profit organizations, and Certified Development Companies. SBA loans have similar documentation requirements as banks, as well as similar timelines for approval and funding.
When You Should Apply For An Alternative Loan
More businesses are turning to alternative loans for a number of reasons. Difficulties qualifying for conventional loans and the need for fast financing are two of the biggest reasons alternative lenders are becoming more popular in the small business world.
Alternative loans typically have requirements that are less strict than bank and SBA loans. This means that businesses with lower credit scores, startups and new businesses, or businesses that donât have a lot of revenue can qualify.
The process for getting approved and funded is also much quicker and easier. There are usually fewer paperwork requirements, and in most cases, the entire process can be completed online. Depending on the type of loan selected, the loan amount, and the lenderâs policies, some loans may be funded in just 24 hours.
Credit requirements for alternative loans are not as strict, although higher credit scores yield lower interest rates and better repayment terms. Scores as low as 500 may be approved for certain types of alternative loans. In some cases, collateral will be required for loans, particularly for larger loan amounts or for applicants with lower credit scores.
It is important to note that these loans often come with higher interest rates. Because alternative loans are more expensive, qualified business owners with high credit scores should consider more affordable options.
Business Loan Application Best Practices
Youâre almost ready to apply for your loan, but before you do, itâs important to understand a few best practices. While itâs easy to focus solely on the money, itâs also critical to present yourself as a professional, trustworthy business owner to lenders.
To expedite the process as much as possible, make sure that youâre thorough in every step of the way. From performing your calculations to determine how much money you need and how much you qualify for to gathering your paperwork, your preparations should start even before you apply for your loan.
Do your research and shop around with lenders to ensure youâre getting the most affordable option. When actually applying for the loan, make sure that youâre prepared as well: know what you want to say and how you want to present your business, and have everything you need to back it up.
Lenders want to work with trustworthy, low-risk borrowers. Lenders donât want to work with anyone thatâs dishonest. Be upfront with your lender about everything, from how you plan to use the money to your current financial situation. Outright lying or even just hiding relevant information will not justÂ make you look unprofessional — it will get your loan application rejected.
In addition to being honest with the lender, be honest with yourself. For example, when calculating how much you can borrow, take a good hard look at the numbers. Lying to yourself will only hurt your business in the long term, leading to unnecessary debt and the potential consequences that come with it.
Be Available For Follow-Up Questions
Once youâve submitted your application, youâre in the clear and itâs just time to wait for your approval, right?
The lender may require more documentation or have more questions for you. Minor delays are common, but these minor delays can become major if youâre unavailable to your lender. Always show respect to your lender by answering phone calls or emails as soon as youâre available.
Applying for a business loan can be intimidating, but with careful planning and a little knowledge, you can move through the loan process like a pro. Be prepared, know your numbers, keep in contact with your lender, and stay professional, and youâll soon be on your way to securing your first business loan.
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