6 Steps to Getting a Small Business Loan

From deciding how much to borrow to signing the promissory note, here are the steps to getting your small business loan.

By , Attorney · University of North Carolina School of Law

Once you've decided that applying for a small business loan is the right choice, you need to know how to get one. You should evaluate your business's needs and research the different types of financing options first before you submit a loan application. Whether you're looking to expand and hire new employees or you've hit a low point in the year for sales, you can find a small business loan that works for you.

Once you've found the right loan, it's time to start the application process. You'll need to gather the appropriate information and documents, which can vary by lender, to see if you're approved.

You can follow the steps below to guide you through the process of getting your small business loan.

1. Decide How Much You Need to Borrow for Your Small Business

How much money you need to borrow depends on your type of business, the stage of your business, and what sort of financial hardship your business is facing.

For example, if you're just starting a business and have letters of intent (formal declarations of an intent to contract) from soon-to-be customers but you need to buy a significant amount of raw materials and equipment, you might need a larger sum of money. But if you've been in business for years, just need to make payroll that month, and expect your money flow problems to be short-lived, you likely only need a small loan.

Unless you already have a number of awaiting customers or contracts in the works, it can be a mistake to pour too much money into your business at the beginning. A fair number of small businesses fail in the first year, so raising and spending a pile of money for an untested business idea can lead to much grief—especially if you're personally on the hook for borrowed funds. Consider starting as small and cheaply as possible.

2. Choose Your Lender and Loan Type

You should have a fairly good idea so far of the types of loans available to small businesses. Evaluate your business needs to determine which loan option is best for you. If you need funding now, consider a term loan from an online lender or a business line of credit. If your need isn't urgent and you've applied for other loans with no success, look into the different SBA-backed loans.

Once you've identified what type of loan you want, find a lender. You have a lot of options if you're looking for a fixed-term loan or business line of credit. You can visit a local bank branch or apply on that bank's website. You can compare your traditional banks with online lenders.

If you're looking for a merchant cash advance provider, you can compare your options online. Look specifically at how much can be advanced and the factor rate. If you think you qualify for a microloan, look at the SBA's list of lenders or find nonprofits that specialize in microfinancing.

Keep an eye out for hidden costs like:

  • application fees
  • origination fees
  • underwriting fees
  • processing fees
  • late fees, and
  • prepayment penalties

Compare business loan rates and payment terms to find the best loan. You'll want to try to find the lowest interest rate under a reasonable term period so you know you'll have the time and money to pay it back.

3. Understand Your Loan's Interest Rate

Your interest rate just might be the most important factor on your small business loan. The lower the rate, the better. Your interest rate is a percentage of your loan that's charged over your loan's life. Lenders charge an interest rate to make a profit and to offset the risk of loaning the money in the first place.

Which is Better: Fixed Rate or Variable Rate Interest Rate?

Some loans have fixed interest rates while others have variable interest rates. A fixed rate can't change during the loan term; a variable rate can.

Often loans with variable interest rates start off low to entice borrowers and can later jump to percentages higher than fixed rates. When national interest rates are low, the variable rate will be low and when national interest rates are high, the variable rate will be high.

Most borrowers favor a fixed interest rate because it's less of a risk. If the economy dips and the national interest rate rises, small businesses that are already struggling with the economic downturn might not be able to afford the sudden higher interest rates. Choosing a fixed interest rate avoid this problem and offers small businesses predictable loan payments.

But some small businesses need the financial head start now and will choose a variable interest rate. If you're confident that your business will flourish once you open your doors, a variable interest rate might be less of a risk.

Can an Interest Rate Be Too Low or Too High?

State usury laws prevent lenders from charging illegally high interest on loans. As a general rule, a lender can safely charge you interest of up to 10% per year and not have to worry about violating their state's usury law. However, there's a lot of variation in usury laws from state to state, and different rules apply to commercial lenders and private lenders, so you should check your state's laws if you're concerned. Look under "interest" or "usury" in your state's statutes.

If your corporation is taking a loan from a shareholder (including yourself), make sure the interest rate isn't too low—the IRS likes to see loans that are commercially reasonable. Otherwise, the IRS might consider the loan as a capital investment by the shareholder and treat the loan repayments as dividend payments to the shareholder.

4. Consider Your Liability on Your Loan

Depending on how your business is organized, if you don't make good on your repayment commitment or default on your loan any other way, a lender has the right to sue you individually (if your business is a sole proprietorship or general partnership) or sue your business entity (if your business is organized as a corporation or a limited liability company). If the lender sues you individually, it can take your personal assets to satisfy the loan. If the lender sues your business entity, it can take the business's assets.

Beyond your business structure, there are several ways that you or a loved one can become personally liable for your small business loan:

  • Personal guarantee. If you're a corporation or an LLC, your lender will probably ask you—the business owner—to personally guarantee the loan or pledge your personal assets to guarantee repayment, particularly if your business can't qualify for the loan on its own. Be aware that guaranteeing your business's loan makes you personally liable for the loan if your business can't make the payments. All of your separate property, and either half or all of any property you jointly own with a spouse (depending on which state you live in), could eventually be taken if you default on the loan.
  • Cosignors. If you're married, the lender might insist that your spouse cosign the loan agreement or promissory note. Unlike a guarantor, a cosignor is immediately responsible for making loan payments, regardless of whether your business falls behind. If your spouse cosigns the loan, not only is your jointly owned property completely at risk for this joint debt, but also any assets that your spouse owns separately—for example, a house or a bank account.
  • Piercing the veil. If you have a corporation or LLC, you're generally shielded from personal liability for business loans and debts. But you can become personally liable for your business loan if the corporate veil is pierced. The corporate veil is pierced either when the court decides that the officers, directors, and shareholders and the corporation act like a single entity or when there's been fraud or other misconduct. Piercing the corporate veil is common in smaller corporations because there's more involvement by individuals in the corporation's day-to-day activities.

Before you apply for a small business loan, it's important to know who's ultimately responsible for making payments on the loan and who could be held financially and legally responsible when there's a default.

5. Apply for Your Small Business Loan

After you've selected a loan and lender and you understand the potential risks, you're ready to apply for your loan. The application requirements change with each type of loan and each lender. Generally, the lender will run a credit check, which usually helps to determine your eligibility and interest rate. Make sure you know your company's taxpayer identification number.

You should also be prepared to provide the lender with these common documents for your business:

You might also need to provide personal financial documents, including tax returns and bank statements if you're personally guaranteeing or cosigning on a loan.

During the application process, you might be required to personally guarantee your small business loan or to put up valuable property (called "security" or "collateral") that the lender can sell to collect their money if you don't make your loan payments. For example, a lender might take a second mortgage or deed of trust on your house, or ask for a security interest or lien on your business's equipment, inventory, or accounts receivable.

6. Review and Sign Your Promissory Note or Loan Agreement

At the end of the approval process—once the loan processing and underwriting are out of the way—you'll finally know your rate and terms of the loan. The lender will either need you to sign a loan agreement or a promissory note.

A loan agreement is used for larger loans and lays out:

  • loan amount
  • interest rate
  • term length—for instance, 5 years or 10 years
  • payment amounts
  • payment due dates
  • policy on late payments
  • what counts as default and what happens if you default
  • prepayment policy—whether there's a penalty for early payments and if so, what that penalty is
  • security interest or collateral, and
  • loan fees.

If the loan is smaller, a lender might ask you to instead sign a written promissory note. A promissory note is a shorter, less formal loan agreement. It lays out the general exchange that the borrower promises to pay the lender the principal and interest on a loan.

A promissory note will usually include a payment schedule and repayment terms. But it typically doesn't discuss in detail—if it discusses it at all—what happens if the borrower is late on a payment, or misses a payment entirely.

Promissory notes are most common between friends and relatives. But lenders can opt for a promissory note when the loan amount is small or the debtor has a history of borrowing from the lender.

Additional Help With Your Small Business Loan

If you have simple financial statements and don't need to customize your loan terms, you can likely complete the application process on your own. But if your business has particularly complex financial statements or you need to personalize loan terms, it might be time to reach out for professional help.

If your financial records are lengthy or complicated, consider meeting with an accountant to go over your company's finances to determine what kind of loan your business needs and how much you can afford to borrow.

If you need guidance on your loan terms or your personal liability for business loans, you can speak with a business finance attorney. They can review and negotiate the terms of your loan agreement to tailor your loan to your business needs. They can also clearly explain the potential liability for your specific situation.

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