Best business loans

How do business loans work?

What is a business loan?

Business loans are a form of credit lending that are exclusively available to companies.

Like most other loans, they involve borrowing a sum of money and repaying the amount, plus interest, over a given period of time.

Interest will be charged at either a fixed or variable rate. Taking out a fixed business loan means the interest rate will remain the same for part, or all, of the term. With a variable business loan, however, the interest rate could go up as well as down over time.

Companies will often find they’re able to borrow a greater amount with a business loan compared to individuals applying for a personal loan.

Related guide: Business loan vs personal loan: Which should I choose?

Who is eligible for a business loan?

In order to apply for a business loan, you’ll need to be a UK resident aged 18 or over who either already owns or is planning to start a business.

Although eligibility criteria can vary from lender to lender, most will take into consideration factors such as your personal and business credit rating, your business plan and any assets that could act as security for the debt.

Ultimately, a lender will assess whether you’re a reliable borrower who can be trusted to meet the loan repayments.

What are the different types of business loans?

There are many types of business loans available which suit a variety of different needs and circumstances:

Secured business loans

A secured business loan requires you to provide an asset, such as property, to act as collateral. If your business were to default on the loan, a lender could repossess this asset and sell it to cover any outstanding debt.

Depending on the value of the asset you put down, you may be able to borrow a larger amount of money with a secured business loan. Often seen by lenders as a lower-risk option, some may even charge a lower rate of interest compared to an unsecured business loan.

Unsecured business loans

If your business doesn’t have any assets valuable enough to act as security for a debt, or you’d rather not risk having your assets repossessed, you could opt for an unsecured business loan.

This type of loan doesn’t require any collateral. Instead, lenders rely more heavily on your personal and business credit history to determine whether you can be trusted to meet repayments.

However, the amount of money you can borrow with an unsecured loan will often be smaller than with a secured loan. You’ll also usually need to sign a personal guarantee that holds you, as an individual, responsible for repaying the debt if your business were to default.

Related guide: Personal guarantees: What are they and how do they work?

Term loans

Term loans are defined by the amount of time you have to repay the debt:

• Short-term loans

Businesses experiencing temporary cash-flow problems, or which have encountered unforeseen expenses, may be interested in short-term business loans.

As suggested by the name, these loans are repaid over a shorter amount of time compared to most standard loans. This can make them a more cost-effective option, despite typically having higher rates and larger repayments, as they accrue less interest over time.

What’s more, as lenders often perceive short-term loans as less risky, they often have more lenient eligibility criteria and a quicker approval process. However, the amount of money you can borrow will usually be less than with a standard or longer-term loan.

• Long-term loans

In contrast, long-term business loans offer a longer window to repay the debt. This may appeal if you’re looking to borrow a more substantial amount of money to grow your business over a prolonged period of time.

While long-term loans tend to come with lower interest rates and less expensive repayments than other terms, it’s important to remember your business will repay the debt for longer. This could be made difficult if you or your business were to experience a change of circumstances in the future.

Merchant Cash Advance

A Merchant Cash Advance (MCA) offers an alternative to traditional business loans. This type of lending involves an MCA company providing an upfront lump sum which you then repay using a percentage of your future debit and credit card transactions.

As well as the lump sum, you’ll also need to pay a fee, known as a factor rate. However, be aware this will often be more expensive than the interest rate charged by other types of loans.

When it comes to repaying an MCA, meanwhile, you’ll also need to keep in mind there are no fixed repayments or set term; the amount you repay and how long it takes to repay the advance will depend on the volume of debit and credit card transactions your business makes each day.

Credit lines

For a more flexible form of borrowing, you could consider a credit line (or ‘line of credit’). Like a credit card, this allows you to borrow money at any time, up to a preset amount. A lender will determine this upper limit by using your personal and business credit history to gauge your creditworthiness.

Once established, you’ll be able to withdraw funds from your credit line at any time. You’ll need to meet minimum repayments each month but could pay more to clear any outstanding debt.

If you take out a revolving line of credit, you can continue borrowing from the funds as soon as they’ve been repaid without the need to reapply.

Working capital loans

If you’re only planning to use a loan to finance the everyday running of your business, a working capital loan may best suit your needs. This type of loan can be used to cover costs such as rent, salaries and suppliers.

Peer-to-peer lending

Instead of applying through a bank, building society or credit lender, you could use a peer-to-peer (P2P) lending platform or broker to search for individual investors willing to loan your business money.

You’ll typically need to pay the platform or broker a fee upon being matched with a lender. As usual, you’ll then repay the loan, plus interest, over an agreed period of time.

Start-up loans

Specifically designed for new companies, a start-up loan is a way for businesses less than three-years old to access financing.

Most of these loans are unsecured, as it’s understood new businesses will have limited assets to act as collateral. This, combined with start-up companies often being perceived as riskier by lenders, means this type of loan usually comes with higher interest rates.

• Government-backed Start Up Loan

The government backed Start Up Loan scheme allows fledgling businesses to borrow between £500 to £25,000. Applicants are given free support and guidance to prepare a business plan, while successful candidates will also receive up to 12 months free mentoring.

However, it should be noted this is an unsecured personal loan rather than a business loan.

How to apply for a business loan

When applying for a business loan, there are a number of questions you’ll need to know that answers to. These include:

What is your business plan?

While not a requirement for all lenders, having a business plan could greatly improve your chances of being approved for a business loan.

This is because a comprehensive and carefully considered plan demonstrates to lenders a sound understanding of your business, the market and your goals.

In your business plan, it’s usually a good idea to expand on how you intend to use a loan to grow your business and show you’ll be capable of meeting repayments.

How much money do you want to borrow?

As part of your application, you’ll need to specify how much money you want to borrow. Depending on the type of business loan, the lender and your financial history, this can range anywhere from thousands to millions of pounds.

How long will it take you to repay the loan?

You’ll also need to consider how long it will take to repay the debt – many of the loans on our chart come with terms between one and 25 years.

How much can you afford to repay each month?

While spreading the cost of a loan over a longer term could help minimise monthly repayments, bear in mind this will usually see you pay more in interest over time. Conversely, a shorter term means your loan will accrue less interest, but you’ll need to cover larger repayments each month.

Once you’re ready to apply for a business loan, you’ll need to supply a prospective lender with proof of your address and ID. You may also be asked to provide supporting documents, such as bank statements, tax returns and financial accounts.

Furthermore, you’ll need to show evidence of any other forms of business finance you’ve secured. Similarly, you should include details of any assets to be used as collateral in your application.

What are the risks involved with business loans?

Perhaps the biggest risk associated with a business loan is missing repayments. Late payments may incur a charge, while any assets used to secure the debt could be repossessed if the business were to default on the loan entirely.

Meanwhile, if you sign a personal guarantee, you’d need to pay out of your own pocket if the business struggled to repay the debt.

There are also some other pros and cons to keep in mind:

Finding the best business loan

Our chart provides details on a range of business loans currently available, allowing you to compare features such as minimum advances and repayment terms to find the best product for your needs.

Not sure what you’re looking for? Consider seeking advice from a specialist business loan broker.