What Are Small Business Loans and How Do They Work?

If you're seeking a loan for your small business, make sure you understand the different types of loans and lenders, the terms and potential liabilities, and how to apply.

By , Attorney · University of North Carolina School of Law

As you know, a loan is based on a simple idea: Someone gives you money and you promise to pay it back, usually with interest. For business owners, success or failure can hinge on borrowing money sensibly.

If you're seeking a loan for your business, you'll need to know:

  • what types of loans and lenders are available
  • what to consider when choosing a loan, and
  • how to get approved for a loan.

Types of Lenders for Businesses

You have many options when looking at lenders for your business. For small ventures, friends and family members can be willing to help. But for most businesses, traditional banks might make the most sense. Apart from these kinds of options, you can also look to the government—specifically the U.S. Small Business Association (SBA)—or research alternative online lenders.

Banks and credit unions often have convenient loan application processes. Instead of booking an in-person appointment with a loan officer, you might be able to fill out an application on the bank's website.

If you're applying for a loan online, make sure you understand whether you're working with a bank lender or a nonbank lender like OnDeck or Kabbage. For instance, a nonbank lender will likely require less paperwork, but a bank lender could offer you a lower interest rate. Both bank and nonbank lenders are legitimate options, but you'll need to do your research before making a choice.

If you're more comfortable with a familiar name, then a national bank you've already heard of might be the best fit. But if you're willing to look into nonconventional options, then nonbank or private lenders could be worthwhile.

While you could find a lesser-known loan provider that works better for your situation, typical lenders to consider for your business loan include:

  • national and local banks
  • credit unions
  • the SBA
  • state and local governments
  • online nonbank lenders
  • private investors, and
  • friends and family.

Types of Business Loans

There are a number of loan options out there, ranging from term loans for older, established businesses to merchant cash advances for online businesses. While different types of loans can work well, it's best to find the one that will advance your business in the short and long term.

Here are common loans and financing options for your business:

  • SBA-backed loans (the SBA has different programs with different requirements and uses for the loans)
  • short-term and long-term loans
  • business lines of credit—including fixed (or "nonrevolving") and revolving lines of credit
  • merchant cash advances
  • microloans
  • invoice financing and factoring
  • personal loans, and
  • specific-use loans.

For more information on the types of loans available, see our guide to small business loan and financing options.

Considerations for Your Business Loan

Whether you're looking at one or many loans for your business, it's important to consider the terms and potential liabilities associated with your loan. You'll need to consider the loan agreement (or promissory note) itself, including its terms and concessions. The most important terms to look for are the interest rate and any requirement of a security interest or personal guarantee.

What Is a Promissory Note for Your Business Loan?

When you've been approved for a loan, the lender will either need you to sign a loan agreement or a promissory note. For larger or longer-term loans, the lender will want you to sign a loan agreement. If the loan is smaller, a lender might ask you to instead sign a written promissory note—a paper that says, in effect, "I promise to pay you $XXX plus interest of XX%."

Essentially, a promissory note is an abbreviated loan agreement. Loan agreements have more terms and require more detailed processes for any issues that might come up during the length of the loan. Because promissory notes are usually associated with smaller amounts and shorter terms, the lender can afford a shorter contract because there's generally less to discuss and less potential liability.

While a friend or relative might be willing to lend you money on a handshake, this is a bad idea for both of you. It's always a better business practice to put the loan in writing and to state a specific interest rate and repayment plan. Otherwise, you open the door to unfortunate misunderstandings that can chill your relationship.

Also, you want to have documentation of the loan's terms in case the IRS decides to audit your business. A promissory note can be a great option for personal loans between friends and relatives.

Your Business Loan's Interest Rate

Your interest rate just might be the most important consideration 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.

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.

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 this 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 law if you're concerned. Look under "interest" or "usury" in your state's statutes.

If have a corporation and it's 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.

Security Interests on Your Business Loan

Many lenders will require you to put up valuable property (called "security" or "collateral") that they 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.

If your credit score isn't great or your business income is low, you should be prepared to provide the lender with a security interest in your property to qualify for the loan.

If you feel confident that you'll be able to make the loan payments, then adding collateral might not be a dealbreaker. But if you're less than certain about your business's future performance, it might be best to keep looking for a loan that doesn't require a security interest.

What Is the Personal Liability on Your Business Loan?

You can be personally liable for your business loan depending on your business's structure and how you signed for your loan.

If you're organized as a sole proprietorship or general partnership, a lender can sue you individually if you don't make your loan payments. If you're organized as a corporation or limited liability company (LLC), a lender can usually only sue the business and not you as an individual.

If you're organized as a corporation or LLC, a lender can only sue you individually if:

  • you cosigned or personally guaranteed the loan, or
  • the corporate veil is pierced (and a court rules you're personally responsible for your business's debts).

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.

If a lender can come after you personally, then you should borrow conservatively. For example, if you know you can pay back only $15,000 but your office renovation plans cost $20,000, apply for a $15,000 loan to be safe. Instead, you can negotiate a lower contract price for the remodel or save a less urgent renovation item for later down the road.

Cosigners, Guarantors, and Personal Guarantees on Your Business Loan

A lender might also require that someone cosign or guarantee the loan, which means the lender will have two people rather than one to collect from if you don't make your payments. When asking friends or relatives to cosign for or guarantee a loan, be sure they understand that they're risking their personal assets if you don't repay the loan.

If you've organized your business as a limited liability entity, such as a corporation or an LLC, the lender will probably ask you—the business owner—to personally guarantee the loan or pledge your personal assets to guarantee repayment. (Because small businesses have high failure rates, lenders feel more comfortable if business owners have a personal stake in repaying the money.)

Be aware that guaranteeing or personally cosigning your business's loan circumvents your limited liability status. 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 seized if you default on the loan.

Finally, if you're married, the lender could insist that your spouse cosign. 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, any assets that your spouse owns separately—for example, a house or a bank account—is at risk. Additionally, if both you and your spouse sign for a loan and miss a payment, any property you own together could be wholly taken to satisfy the joint debt.

How to Get a Business Loan

The process of applying for a business loan might differ based on the type of loan and lender. But generally, these are the steps for researching and getting a loan:

  1. Decide how much you need to borrow.
  2. Choose your lender and loan type.
  3. Understand your interest rate.
  4. Understand your personal liability.
  5. Apply for your loan.
  6. Review and sign your promissory note or loan agreement.

For more information on the process for getting a business loan, see the 6 Steps to Getting a Small Business Loan.

Additional Help With Your Small Business Loan

When considering which loan works best for your business, it's a good idea to touch base with an accountant to get a reasonable forecast of your financial health. They can help you determine how much to borrow and how soon you can pay it back.

If you need additional help understanding the terms of your loan agreement or have legal questions about your loan, you can reach out to a business finance attorney. They can review and negotiate your loan agreement and further explain your potential liabilities.

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