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How Does Business Loan Work

Posted: 23rd May, 2022

Updated: 8th February, 2023

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Types of Business Loans and How They Work

A business loan comes under debt financing. This is an option to gain the funds you require to scale your business.

A lender can provide business loans in exchange for guaranteed returns, including interest, on top of the principal loan amount, which is often the most generic loan structure. Interest is usually levied as a percentage of the principal amount taken as the loan.


Term Loan

If a business is eligible for a term loan, it gets a specific sum of income money that it has to pay off along with interest with scheduled payments over a period of time as per the stipulated repayment schedule.

Also, term loans provide loan repayment tenure/lengths generally for a longer duration, which means you could have time from one to five years to repay the total loan amount.

Additionally, term loans often come with lower interest rates. In term loans, the interest rates can go as low as 7%.


Equipment Financing

Equipment financing can be obtained when a business needs funds specifically to purchase a unit or part of the equipment needed for business operations. This is a self-secure loan in a way that the equipment the business purchases with the loan amount itself serves as collateral for the equipment loan.

The terms and conditions of this loan rely on the type of equipment under consideration. With the help of equipment financing, a business can get a loan for 100% of the total value of the equipment part. Also, your loan tenure usually will be the approximate life of the equipment part.

So, as the equipment acts as collateral for the loan, the lender undertakes less when he chooses to lend to the particular business entity. The interest rates in equipment financing are typically affordable, going as low as 8%.


Invoice Financing

Invoice financing is another type of self-secured loan. Invoice financing is a business loan that offers advance capital to the leaders who are yet to receive payments from their outstanding invoices. If you opt for invoice financing, you stand a chance to secure about 90% of the total worth of the invoice. In a way, the invoice can act as collateral for a business loan.

Again, as the invoice itself secures invoice financing, the business owner will have to pay lower interest rates on financing. Interest rates on invoice financing are usually in the form of factor fees charged on an amount held by the lending company, also known as the reserve amount. You may be charged a 3% origination fee or advance fee and a 1% factor fee levied over the principal every week the invoice goes unpaid.

Once the invoices are paid, you may receive the remaining amount of the invoice, for example, the balance of 10% if you had financed 90% of the invoice’s value less the origination and factor fees.


Business Lines of Credit

This type of business loan is a little more complicated in how it functions. A business line of credit is a lot like a business credit card. If your business is eligible for a line of credit, you may get a credit limit that you can draw on a month-on-month basis.

As with a credit card, a business line of credit allows you to repay what you end up spending, preventing you from paying back interest for received funds. However, unlike the typical business credit card, in the business lines of credit financing, you will be dealing with cash and you will not be required to pay extra charges to withdraw any cash advance.

To sum up, the business line of credit is a common business financing product for various small business owners.


Business Loan Procedure

Since we have covered the fundamental understanding of how different types of business loans work, it’s time to check out how you can apply for a business loan.

As we discussed in the previous sections, almost all loan types have minimum eligibility requirements that all business owners need to meet to secure any funds.

Any business owner looking for a business loan would require the mentioned set of documents. To be eligible for a business loan like - time in the business, credit history, financial health and the type of collateral which they can offer, with proper documentation in place and thorough following of procedures. Once it is understood that your business is fit for the loan, getting the loan becomes quite simple.

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