Taking out a business loan can be a big step. The money can solve short-term cash flow issues, provide the opportunity for growth and expansion, or allow a business to spread the cost of a big purchase. Either way, it is important to understand how a business loan works in order to know what effect it will have on your company. In this article we will explain how a business loan works, what you can expect from the application process and why repaying the debt on time is so important.
How does a business loan work?
Business loans work in a similar way to personal loans. A business applies to borrow a specific amount of money from a lender and repay it over a set period of time. The lender then decides whether to approve the application, reject the application or offer to lend a different amount. At this stage, the lender will also decide what interest rate to offer the business. The interest on the business loan is essentially how much the applicant will need to pay in addition to repaying the borrowed money.
How much a business is able to borrow will depend on a whole range of factors. The most prominent factors are financial history, credit history and the value of any assets put up as collateral to guarantee the loan.
You can read our article ‘What is a business credit score?’ to learn more about how a business's credit history can affect an application.
Repaying a business loan
A business loan can be repaid over a few weeks or many years, depending on how much has been borrowed and how long the business will need to repay the debt. The longer the repayment period, the lower the monthly repayments. However, longer loan periods mean there is more time for interest to build up and compound, making the loan more expensive. We explain how long-term business loans work in our article 'What are long-term business loans?'.
The monthly repayments will need to be low enough to be affordable for the business. This could mean the loan term is longer in order to split the repayment over more months. Too high a monthly bill could lead to missed repayments, which can damage a company’s credit score, potentially leaving individuals liable for the debt as well as risking property or assets that have been put up as security.
We have more on the basics of a business loan in our article ‘What is a business loan?’.
What are the different types of business loan and how do they work?
There are many different options for a business when it comes to accessing credit. The best fit for your company could be to find the most flexible borrowing option, the loan with the lowest interest or the deal with the longest repayment period. The best way to pick the right option is to do your research and learn how each works. Below we provide some information on how the main types of business loan work:
- Bank loans: You can apply for a business loan with most local high-street banks. The interest rate you are charged may not necessarily be the cheapest available, but there can be other benefits to borrowing from a bank, especially if your business also holds a current account with the lender. We cover the advantages and disadvantages in our article 'Pros and cons of a business bank loan'.
- Unsecured business loans: Business loans are either secured or unsecured. The interest rate you are charged on an unsecured loan, the amount you can borrow, the length of the loan term and whether your business is accepted at all will be based on the company’s financial circumstances and credit history, rather than the value of a specific asset.
- Secured business loans: The key details of a secured loan – the amount you can borrow, the length of the loan term and whether your are accepted – are all based on the value of the asset you secure the loan against. If the loan is not repaid, the asset can be sold to cover the debt.
- Lines of credit: This is a form of revolving borrowing. Like with a credit card, a business can borrow up to a certain limit and only repay the amount borrowed, plus interest.
- Invoice financing: A business essentially sells a debt it is owed to a lender. The lender pays the company in exchange for a percentage of an unpaid invoice. When the invoice is paid, the money goes to the lender instead of the business.
- Working capital loan: This is a short-term loan that can be used to manage short-term cash flow issues and cover any day-to-day running costs of the business. It is not usually a long-term solution to any financial troubles.
- Government Start Up loan: This is a type of loan that is backed by the UK government. It is exclusively for businesses that have been trading for 36 months or less in order to support growth and tackle any early cash flow hurdles. There is more information on the Start Up Loans website. We also cover other types of startup loans in our article 'What are business startup loans?'
- Asset financing: This is a way of borrowing money to spread the cost of business equipment or machinery. The purchases are paid for in regular instalments over an agreed period of time instead of upfront.
- Merchant cash advances: The money lent to a business is a cash advance based on expected future revenue. Once this revenue starts coming in, repayments are then made through deductions from the company’s earnings.
How business loans work: Advantages and Disadvantages
A business loan will not work for every company. Here are some advantages and disadvantages to weigh up when you think about applying for credit.
Advantages of a business loan
- You can use the money to cover most business expenses, from long-term investment to solving short-term cash flow problems
- Borrowing can be a tool to access money more quickly than accumulating cash through excess revenue.
- Your business can grow at speed without the need to wait for income to increase enough to pay for more staff, extra equipment or a relocation.
- Business spending can be paid for over a long period of time. This can help the company grow cash reserves without limiting big purchases.
- The business can access finance without you needing to sell a stake in the company. This means you can get the money you need without giving up control.
- A business loan is usually repaid in regular instalments over a specified period of time. This means you can plan for the future knowing what the monthly costs will be.
Disadvantages of a business loan
- How much you can borrow, how long you can borrow it for and how much the borrowing costs will all depend on the business’s credit score. In some cases individual credit scores will be checked too.
- Borrowing usually costs money, so the business will need to repay the debt with interest.
- With a secured business loan, a valuable asset will be at risk if the business cannot repay the debt.
- Missing regular repayments will likely lead to hefty fees, additional interest and accessing credit becoming more difficult for the business in the future.
- Some business loan providers will require the debt to be personally guaranteed by a company director. This individual will then be liable for the debt should the business be unable to repay the money.
Applying for a business loan
Applying for a business loan should be a simple and straightforward process. Once you have found the right product and the right lender, you can usually choose to apply online, over the phone or in a branch.
The lender will likely require certain information about your business and – in some cases – personal information about yourself or other individuals involved in the company. You will usually need to provide information on revenue and costs. This could be through bank statements or company accounts. You may even need to supply a business plan showing how you expect company finances to change in the future. This is all to show the lender that you can be trusted to repay the loan and that the business will make enough money to be able to afford the repayments.
With a secured business loan, the lender will need details on the asset being provided as collateral. This could be in the form of a property valuation or proof of purchase for expensive equipment.
The lender will take all the information you provide and decide whether your business will be accepted for the loan or not. It will also run a credit check to test the creditworthiness of the business. It can be useful to check your credit score before you apply for a business loan in order to correct any issues or make any quick fixes so that your business is more likely to be accepted.
We explain business loan eligibility in our article 'Who can get a business loan?'.
Who can apply for a business loan?
In most cases the person applying for the loan will need to be a registered company director. If you are unsure whether you are eligible to apply for a business loan on behalf of your company, check with the lender first.
Established businesses will likely find it easier to get a business loan, but there are lenders that specialise in loans for small businesses. You can learn more by reading our article 'How do small business loans work?'.
We explain how the application process works in our article 'How to get a business loan'.
How does a company credit rating work?
Just as with any individual applying for a loan, a business will have a credit file that is checked by a lender during the application process. The lender will want to know what a company’s credit history and financial circumstances show about its creditworthiness – essentially whether or not it can afford the repayments and can be relied upon to clear the debt. You can read our article ‘What is a business credit score?’ to learn more.
Credit files are held by multiple credit reference agencies (CRAs), including big names like Experian and Equifax. This means that your business – like yourself – will not have one universal credit score. A business credit file will include information held by the Registry Trust – such as details on any CCJs (County Court Judgements) – and Companies House, among other sources.
You can make sure your company's credit score is in the best possible shape by avoiding any CCJs and filing full accounts on time with Companies House. A poor credit score will limit your business’s credit options, but it will not necessarily close off borrowing entirely. There are steps you can take to improve your credit score, or you can look into loans aimed at companies with a varied credit history. We have more information in our article ‘How to get a business loan with bad credit’.
Will my personal credit rating matter?
Running your business as a sole trader or through a partnership will mean your personal credit rating is judged alongside your business credit rating. This will also be the case if your business is a limited company, but has little financial history.
The reasoning behind this is that without its own credit record or financial history, separate from any personal borrowing, a business cannot be fully assessed by a CRA. Instead, the CRA will need to look at individual credit history to judge a potential borrower.
This all means that it can be valuable to keep an eye on your personal credit score before you apply for a business loan. It is easy to check your credit history, as we explain in our article 'The best way to check your credit score for free'. We also show you how to boost your score in our article 'How to improve your credit score quickly'.
What happens if a business loan application is declined?
Missing out on a business loan can be stressful and worrying, but it does not need to be a disaster. The best way to avoid any further issues is to not apply for another loan straight away. Making multiple applications over a short period will likely damage your credit score and make future borrowing more difficult. Instead, take the time to assess your financial situation and understand why your application was rejected.
Contact the lender to get an official reason why your business was turned down. In some cases, this could have been because of a small issue that you can easily resolve. In other cases, it can give you an idea of what area your business needs to work on to improve its creditworthiness.
You could also take advantage of the Bank Referral Scheme, which is a programme backed by the UK government. It requires that a business turned down by a participating lender – such as major banks Lloyds, HSBC, Santander, RBS and Barclays – is referred to an alternative provider. The alternative options are usually specialist online platforms, rather than other big-name banks. There is more information on the British Business Bank website.
How does a business repay a loan?
Once the money is in your business bank account, the next job is to start paying it back. The funds will usually be moved to a nominated account soon after your loan has been approved. Exactly how long it takes to get the cash will depend on the provider, so check to see when you can expect the money before you apply.
Different loans are repaid in different ways, but you will usually need to set up a regular direct debit or standing order to meet the minimum monthly repayments on the debt. In some cases the money the business owes will be taken directly from outstanding invoices as they are paid or as a percentage of the company’s revenue as it comes in.
What happens if a business cannot repay a loan?
Missing repayments on a business loan – just like with a personal loan – will usually be expensive. Most lenders will charge late payment fees and administration fees, as well as additional interest on the money you have not paid back on time.
Missed payments will also hurt your company credit score and potentially make it more difficult to access borrowing in the future. It will be especially damaging if the loan is not repaid at all and the company defaults on the debt. The number of missed repayments that trigger a default will depend on the lender, with the exact terms usually listed in the loan agreement. The lender could also attempt to claim any assets used as collateral or pursue any individuals who have guaranteed the loan, such as a company director.
Fortunately, most lenders will prefer your business to pay back the loan in full, rather than take any expensive steps to recover the money. Any business that is struggling to repay a loan should contact the lender, as it may agree to a new, affordable repayment schedule.
