Types of loans
Business loans tend to come in one of two basic forms:
- Term loan: A lump sum you get all at once, with a regular repayment schedule over a set period of time.
- Line of credit: A pool of funds you can dip in and out of with flexible repayment amounts and interest charged only on the amount of money you use.
What are term loans?
Personal term loans, business term loans, startup loans, business mortgages, commercial property loans, and asset loans are all types of term loans. These names denote the purpose of the loan, which may affect the amount you can borrow.
Where term loans vary is in the interest rates charged, repayment terms, and security required. Let’s look at those options:
Interest rates and repayments
- Fixed: You lock in one interest rate over the term of the loan. This can help with budgets and forecasting. But you’re likely to be charged an early repayment fee if you pay back the loan before the end of the fixed term.
- Floating (or variable): The interest rate can go up or down. If the rate goes up, so do your repayments. But if it goes down, you can either reduce your repayments or leave them the same and pay off the loan faster. Floating rate loan repayments are often more flexible; you can change the repayment amount, pay off lump sums whenever you like, and often pay the whole loan back early without penalty.
- Secured: If you can provide some type of valuable asset or personal guarantee as security you may find it easier to borrow, and get a larger amount. But if you fail to make repayments, the lender can take the security as their own. Some lenders might offer partially secured loans where the security isn’t worth the full value of the debt.
- Unsecured: This is a more expensive but less risky option, where you promise nothing as security. Interest rates and fees tend to be higher and it’s hard to get if your credit history is poor. The amount you can borrow is also generally lower.
Term loans are often used for long-term investments, such as buying a business or large assets. They’re also a good option for businesses with regular income because they can budget repayments and term loan interest rates are lower than line of credit rates.
The longer you’ve been in business the easier it usually is to get a term loan. Lenders like to see a successful track record.
What is a line of credit?
Revolving credit facilities, overdrafts, and credit cards are all a type of line of credit. They give you access to extra cash, but you’re only charged interest on the portion of the money that you use.
Interest rates and repayments
- You only pay interest on the amount used. If you don’t use the money you’ll make no repayments. But you may have to pay a fee for having the facility. If you go over your limit or repay late, your interest rate may go up drastically or you’ll have late payment fees added.
- Can be secured or unsecured. Unsecured lines of credit tend to involve less cash and have higher interest rates.
Business lines of credit are often used for short-term finance. They can help you ride out seasonal lulls or cover unexpected costs. They’re also handy for making purchases that are too large for a credit card but too small for a term loan.
Line of credit or business credit card?
A business credit card has the benefit of being useful for online purchases and ad hoc expenses, and keeping your business and personal spending separate. Some also offer an interest-free period, reward programmes, extended warranty insurance on purchases, and liability waiver insurance against misuse by other cardholders. As a bonus, they also allow you to track and categorize spending more easily.
However, they have higher interest rates and fees, and smaller credit limits than a line of credit, and they may require a personal guarantee which could affect your personal credit rating if payments are late. Protections and services may also be less than those offered with personal credit cards so it pays to check with the provider.
How to apply for a loan
Lenders ultimately want to know you’ll repay them. Take your time preparing important documents, make sure you complete everything they require, and follow the instructions carefully.
To apply for a business loan, you will need:
- Business plan: Your business plan needs to explain the size of the opportunity and show how you’ll take advantage of it. You should also show the lender specifically how the loan would be used. Key risks should be identified, with a plan for managing them.
- Financials: Provide a budget showing how you’ll afford repayments. If the loan is for an existing business, the lender will want two years of profit and loss reports and possibly tax returns. The budget should be realistic and based on sound assumptions.
- Creditworthiness: Banks want to see that you have a good record of paying bills and debts. They’ll check out your credit rating or credit score in business and possibly your personal life.
- Security: Not all loans are secured but if you want to borrow a lot, you’ll be expected to offer something in return. If you provide some form of security, the risk is that the bank can take it if you stop making repayments. If you offer a personal guarantee, the risk is that they may sue you if you can’t repay the loan.
Lenders aren’t especially concerned if your business becomes the next big thing. They don’t have shares in it. They love a steady, predictable yield. So you don’t need a wow factor to apply for a loan; you just need to demonstrate that you’re a good solid bet.
How technology can speed up your application
It can be much simpler and faster to apply for loans if you use software to keep your business accounts. Here’s why:
- You can save time: Sharing financial reports from your software means you don’t need to print them off, fill them out, and share them manually with the lender.
- You can get a decision sooner: Giving the lender instant access to the financial reports allows them to assess your application faster.
- Lenders will see a true representation of your business: Accounting software makes it easier to keep your financial information up-to-date, so the lender can more clearly see how your business is tracking.
Check if your lender can connect with your accounting software in this way.
Types of lenders
The main types of lenders are:
- traditional banks
- online and alternative business lenders
- peer-to-peer lenders
Banks come in many sizes – some are global, some national, while others are regional or community-based.
Because of their size, traditional banks often have the best business loan interest rates. They can also package a range of financial services for you. They might, for instance, combine a term loan and line of credit with deposit accounts and business insurance.
Banks aren’t as speedy as some other lenders when it comes to processing and approving loans, but they’re getting better. Some can make faster decisions if they have digital access to your financial records through online accounting software such as Xero.
Banks are more likely to approve a loan application if you have:
- provided a lot of the funding yourself (or can provide solid security)
- have prior industry experience or a business track record
- have a really credible business plan
It can be hard for startups to get big loans through a bank. Before putting the time into an application, speak with a bank manager, accountant or bookkeeper to see if your application will have a chance.
Online and alternative business lenders
Many online lenders focus solely on finance – they don’t provide other types of services. Some specialize in certain industry sectors.
If you’re a startup business, have a less than shining credit history, or no security, these lenders may be more approachable than banks.
They often focus on short-term and unsecured loans and frequently work faster than traditional banks. They accept online loan applications and may approve your loan within a day. On the flipside, their rates, fees and terms may not be as competitive as traditional banks. That’s how they manage the risk of offering unsecured loans.
Peer-to-peer (P2P) lending platforms match people who want loans with people (or institutions) who are willing to fund them. The peer-to-peer platform oversees the application process, repayments and, if required, the security.
Application and approval processes are online and quite often faster than banks. You don’t necessarily get all your funding from one person – multiple people might contribute.
The loans are usually fixed rate, short term and smaller than those offered by traditional banks. Interest rates can also be lower than at a traditional bank.
What’s the right type of lender for you?
Don’t go to the first lender you see. Make a list of potential lenders and compare them on things like:
- lending products offered (do they offer good term loan and credit deals?)
- interest rates, fees and early repayment penalties
- lending limits
- ability and authority to make lending decisions quickly
- friendliness toward small and/or local business
- what other services they offer that you might need (such as deposit accounts, international services, business insurance)
If you have personal bank accounts with a provider, consider approaching them. They can quickly see how you operate your personal accounts and this may work in your favour – providing you’ve been a good customer. If you have a mortgage with the bank, they can see what equity is available for you to use as security for business lending.
Talk to an accountant or business advisor about which lenders their clients have found to be supportive.
Lender pros and cons
Online and alternative lenders
Disclaimer: Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the provided content.
How to finance your business
Need finance for your business? Learn about the types of finance, approaching lenders and investors and more.
- What is business finance?
Your new business idea is ready to go. Now you need to find the right small business funding. But where do you start?
- How much business funding do you need?
Knowing how much money you need will help you choose the right type of finance. These tips will help you find a number.
- Debt versus equity finance
Most forms of funding fall into one of two camps. Let’s look at the main pros and cons of debt versus equity.
- Main types of finance
It takes money to make money. So what sort of finance options are there? Here are the types that fund most businesses.
- How to get a business loan
Getting a business loan is still one of the most common ways to finance a business. So let’s look at how to get one.
- Peer-to-peer lending
Peer-to-peer lending is an alternative method of getting a business loan. How does it work?
- Friends and family loans
Friends and family loans may be available when other types of finance aren’t, but they do require some precautions.
- Invoice financing
Ever thought your cash flow would be better if everyone just paid what they owed you? Well, you may not have to wait.
- How to find investors
How do you find investors for equity financing? Let’s look at what types there are and where to locate them.
- Angel investors versus venture capitalists
Angel investors and venture capitalists are alternative finance sources. What can they offer your business?
- How crowdfunding works
Crowdfunding can get you the money to build a business, and the attention to build a customer base.
- Small business grants
Grants are a great funding option for some businesses. They can be a lot of work to get, but the reward is free money.
- Pitching for business funding
Seeking business funding is a major step but you needn’t be daunted. Here’s how to pitch your business.
- Tools and guides for your business
Now that you’re in business, you want to stay there. Xero’s got resources and solutions to help.
Download the guide to financing your business
Your intro to the different types of finance, including their pros and cons. Fill out the form to receive our finance guide as a PDF.