How Do Business Loans Work? (2024)

The 5.6 million small businesses in the UK account for three-fifths of the workforce and around half of all turnover in the private sector, according to the Federation of Small Businesses (FSB). In other words, they form a vital part of the UK economy.

Securing a business loan can help to either start or grow a business, purchase necessary equipment or finance working capital requirements.

But before you can set about finding the right loan for your business, it’s important to know how business loans work.

What is a business loan?

A small business loan is a type of commercial financing that eligible businesses can apply for from traditional banks, online lenders and credit unions.Businesses can use the funds to cover costs associated with running, growing and developing a business.

How do business loans work?

Business loans provide business owners with financing through a lump-sum payment. In exchange for this funding, your business agrees to repay the money it borrows over time, plus interest and any fees and charges.

Typically with business loans the interest rate is fixed for the term of the loan and the business will make monthly repayments. But the structure and repayment schedule will depend on the specifics of your loan. In some cases, the interest rate may be variable.

Business loans are either secured or unsecured (more on types of business loans below). Secured loans require the business to put down collateral (the security), something of value the lender can repossess if you fail to repay, as a way of backing the loan. Usually the security will be property, business equipment, cash or investments.

In contrast, unsecured loans do not require collateral. Instead, you typically have to sign a personal guarantee agreeing to accept personal liability if the business can’t repay the debt.

What are business loans used for?

Business loans can be used for a range of different purposes. When you apply for a loan you will usually need to let the lender know how you intend to use the funds. Common uses include:

• Start-up costs
• Property purchase, upgrades and renovation
• Cashflow for everyday expenses
• Debt consolidation
• Equipment purchases
• Inventory purchases
• Business acquisitions
• Business expansion
• Business franchising
• Marketing and advertising.

Lenders will not allow you to use business loans to cover personal costs like a residential home purchase, personal vehicles or other transactions that aren’t related to a business need.

Common types of business loan

There are a number of different types of small business loans:

Unsecured business loans: these are not secured against assets but, as a result, may be more difficult to obtain than secured loan. Unsecured loans may suit smaller companies who need smaller, shorter-term loans, for example.

Start-up business loans: these are for new businesses that have been trading for less than two to three years. These include the government-backed Start Up Loan which is an unsecured loan, available up to £25,000 for eligible applicants.

Peer-to-peer business loan: you can borrow money from private investors through a peer-to-peer platform (P2P) rather than a bank. You may need to pay a fee to arrange the loan, so check any fees, charges and interest rates before committing.

Cash advance: a cash advance business loan (also known as merchant cash advance) allows you to borrow money against your business’ future credit or debit card sales. The amount you repay monthly will be based on a pre-agreed percentage of your card sales, so you’ll pay more when your business is doing well and less when it’s not.

Invoice finance: the lender uses your unpaid invoices as security to lend to you. There are two main types of invoice financing: invoice factoring, where you can borrow a percentage of the value of your invoices and the lender will collect payment direct from your customers, and invoice discounting, which allows you to borrow against the value of your invoices, but you’ll collect money from your customers and then pay your agreed fee.

Business loan requirements

When you’re looking into getting a business loan you’ll need to take into account the requirements of the loan provider and your business’ eligibility.

Lending policies and eligibility criteria will vary widely between different providers. The type of loan, such as secured or unsecured, will have an impact on the lender’s criteria and what documentation may be needed before a loan can be approved.

But in general, you can typically expect the following requirements and assessments for business borrowing:

• Annual turnover. Most lenders will have a minimum business revenue or annual turnover requirement to be eligible for a loan. This might vary widely depending on the type of loan and how much the business wants to borrow
  
• Time in business. To be eligible for some loans the business will need to have been trading for a minimum time, such as three years. But there are loans available for newer businesses, such as start-up loans
  
• Credit score. Lenders will carry out rigorous affordability and credit checks before giving your business a loan. It may have a minimum credit rating requirement before it will lend. If the business has had payment or credit problems in the past and a loan application is rejected, typically the lenders will explain the reasons
  
• Debt ratio. This is the ratio of a business’s assets relative to its total debts. Lenders will usually assess this at the point of making a decision on a loan application
  
• Security. With secured loans the lender will need you to put up some security as collateral against the loan, this might be a business property or other assets for example. The lender will want to make a valuation to ensure they are satisfied with the security your business puts forward. Bear in mind the risks of secured lending. If your business is unable to keep up with the loan repayments your assets (the security) can be seized by the lender to cover its losses
  
• Personal guarantee. Some lenders and loan types require a personal guarantee, which protects the lender in the case of a default. But it means if your business can’t pay or meet its loan agreement terms, the lender will require you to repay the debt with your personal funds.

On top of examining business loan requirements, you may also want to look over common problems that could prevent you from getting a small business loan, such as a low credit score. Sometimes knowing what not to do before a business loan application can be as helpful as understanding the steps you need to take to apply.