What you Need to Know About Small Business Loans

As a small business owner, you’ve grown used to learning as you go. You had to learn how to manage your accounting, how to address licensing and permitting issues for your industry, how to market your business. The same is true when applying for your first small business loan—a process riddled with unexpected requirements and fine print that will bring an entirely new set of lessons to be learned.

Before accepting your first small business loan, get ahead of the learning curve by asking these six important questions.

How much can you afford to borrow?

In an ideal world, every business owner would be able to borrow the exact amount they needed to achieve their business’s goals. But before you get in too deep, it’s important to make sure that you can actually afford that desired loan amount without creating undue stress for your business.

The best way to determine how much loan you can afford is to calculate your debt service coverage ratio (DSCR). This ratio tells you and your lenders how much cash you have remaining after all your monthly expenses are paid, and will give you a better idea whether you can meet the extra cost of a loan.

Your DSCR can be calculated on either a monthly or annual basis using this simple formula:

Cash Flow / Loan Payment = DSCR

All lenders will require that you have a DSCR of at least 1. However, most lenders will require that you have a DSCR of 1.5 or greater. Use this formula against a few different loan amounts and options to find an affordable borrowing situation that you’ll be comfortable with for the life of your loan.

Will your personal credit impact what loans you can get?

First-time business borrowers are often surprised to learn how significantly their personal credit rating as business owners will impact their business’s loan options. But especially if you have a relatively new business, your personal credit score may be the single most significant factor impacting your eligibility.

Borrowers with a FICO credit score above 700 are typically excellent loan candidates. If your credit score is between 640-700, you’ll likely still have several options available, depending on your business’s other financial factors. If your personal credit score is under 600, you may struggle to be approved for a loan.

Before applying for your first small business loan, check your credit report with the three major reporting bureaus—Experian, Equifax, and TransUnion—to see the FICO credit score that lenders will be seeing and to make sure that your credit report is accurate.

What paperwork will you need?

As you’ve probably assumed (or even dreaded), applying for a small business loan tends to involve a lot of documentation and paperwork. Document requests can vary from lender to lender, but here is a general overview of the documents you should prepare to provide when applying for your first small business loan:

Business organization and legal documents:

  • Articles of Incorporation, Shareholders Agreement, LLC Agreement, Partnership Agreement, Doing Business As filing, or similar
  • All relevant business licenses and permits
  • Title deeds for any real estate owned by the business
  • Patents, copyrights, trademarks, or other proof of intellectual property rights
  • Lease documents for all business premises
  • Title deeds on personal real estate for possible collateral

Banking and tax documents:

  • Business income tax returns from the past two years
  • Personal tax returns for the past two years
  • Property, business, sales, municipal, or other tax statements
  • Bank statements from the previous six months
  • Payroll records from the past six months

Financial statements:

  • Current balance sheet
  • Profit and loss statement for both year-to-date and the previous two years
  • Accounts receivable statement

At first glance, the list can certainly seem overwhelming—but don’t panic! These are all documents that likely already exist in some form. Tackle the list one item at a time to compile the information you need, and you’ll feel totally prepared when you sit down to complete your first small business loan application.

Will you need to offer collateral?

To protect themselves from defaulted (or unpaid) loans, most lenders will require some form of collateral to guarantee your small business loan. This collateral may come from your business—such as company inventory, equipment, or cash savings. But if these assets are deemed inadequate, lenders may ask you to put up your personal assets as collateral, such as your car, your family home, or other valuable personal property.

If you don’t have collateral to offer (or aren’t comfortable doing so), that doesn’t necessarily disqualify you from getting a small business loan. Look into an asset-based loan like invoice financing or an equipment loan—which typically don’t require personal collateral—or consider bringing in a cosigner who can leverage some of their assets instead.

How much will the loan cost?

Different loan products calculate their interest rates in different ways, making it difficult to compare costs. To determine the full cost of your potential loan—and to accurately compare costs among various loan products, you’ll need to calculate the loan’s APR, or annual percentage rate.

Use an appropriate APR calculator for your loan product to make sure you’re comparing like rates and understand your true cost of borrowing. The APR will show you the full and standardized annual cost of borrowing on a particular loan, including any fees and regardless of the loan’s repayment schedule.

When and how will you pay back the loan?

Before you sign that dotted line, it’s critical that you understand exactly how you’ll be expected to repay the loan, so that you can set your business budget accordingly. Will you be making monthly, weekly, or daily loan payments? How long will you be repaying your loan? Will you pay the same amount at every repayment period? What penalties are in place for late payments? Are there any penalties for paying off the loan early?

Use an amortization schedule to see a roadmap of when and how you’ll repay your small business loan, and set your business budget accordingly. Your business’s future credit will depend on your ability to make payments on time, every time, so make sure you set yourself up for success.

Taking out your first small business loan can be a daunting process. But by asking the right questions and doing your homework before you apply for funding, you will lay the groundwork for a positive borrowing experience.