Why Getting a Small Business Loan is Difficult

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A small business loan is an amount of money borrowed from a financial institution by a small business person to start, run, or expand a small business.

Getting a Small Business Loan is Difficult

Unfortunately, financial institutions are notoriously reluctant to lend to small businesses - according to a recent survey by on-deck of over 10,000 business loan applicants in the U.S. 82% were denied financing by their bank. Loaning to small businesses, especially startups, is a riskier proposition for banks than mortgage lending or lending to larger, established businesses.

In addition, given that the underwriting costs for evaluating, verifying, and processing a small loan is roughly the same as for a larger one, banks can increase their profits by focusing on larger loans to bigger businesses (small businesses typically request loans of less than $500,000). As well as being rejected for financing more often, smaller businesses also typically pay higher interest rates on loans than big businesses.

Consider that you may have an excellent credit rating and a solid business plan and still not be able to get a small business loan because you have no collateral. Even established business people can find themselves in this position, if they do not own enough tangible assets, such as houses or other property.

In other words, the small business loan is not being granted on the status of your business; it's being granted on your personal financial status. That's why it's important that your personal financial house is in order before you apply for a small business loan.

You will also find that many lenders just don't provide seed money. While they're perfectly willing to give a small business loan to help a business grow, they don't want to take the risk of lending to a startup.

All that being said, you have a better chance of getting a small business loan if you know where to look and are prepared to meet the lender's expectations. Keep in mind that the overarching consideration of lenders is risk management and approval will hinge on their assessment of your ability to pay back the loan.

Increasing the Odds of a Successful Loan Application

Aside from sufficient collateral, financial institutions will need the following before considering a loan application:

  • A business plan document that outlines your company, products, target market, staffing, cash flow, and other financial projections, etc. Banks scrutinize business plans to reassure themselves that the business they are lending to is likely to be successful. As such, the business plan needs to demonstrate a solid business model backed by sound management. 
  • If you are an established business, information such as loans/credit history, bank accounts, and other supporting financial information. You should also include accounts receivable and accounts payable statements, and references from vendors that indicate that you have a solid history of making payments on time. Finally, include balance sheets, corporate tax returns, and (if possible) audited financial statements for the previous few years of business.
  • A personal financial summary, including details of assets such as property, vehicles, investments, etc. and liabilities such as mortgages, loans, credit card debt, etc.

Note that banks will often also require creditor insurance on business loans, which covers repayment of the loan in the case of death or disability of the business owner(s).

Credit Unions May Be a Better Choice Than Banks

Credit unions are an increasingly important source of financing for small businesses. According to the Huffington Post: "From June 2007, the onset of the financial crisis, to December 2015, small business loans outstanding at credit unions more than doubled—growing by slightly more than 130% over the period. Those loans at banks actually shrank by 10% during that time."

Credit unions are smaller, more locally oriented institutions and as such are more likely to lend to small businesses in their communities. Banks, on the other hand, have gotten larger and more national (and international) through mergers and acquisitions. The larger the institution the less likely decisions (such as lending policy) are made at the local level.

Examples: Steven's application for a small business loan was rejected because he didn't have any collateral.

Community Investment Funds

Community Investment Funds are non-profit organizations dedicated to helping people who can't get the loans they need to get on their feet from a traditional lending institution (such as a bank or credit union), often because they don't have the credit history or collateral that a traditional lending institution demands. Some of these Community Loan Funds will also assist people with poor credit histories (although they will likely insist that you go through credit counseling).

So if you have no credit history or collateral because of divorce, because you're a new immigrant or because you're young, or if you have a poor credit rating because of repayment issues, your local Community Loan Fund may be willing to give you a small business loan.

Your business venture has to be local, though. Community Investment Funds get their working capital from their own communities. While a particular fund may have some government support, typically the bulk of the loan funds come from investments solicited from churches, service groups, and local businesses.

Different Community Loan Funds have different lending parameters so don't immediately write them off as a potential source of start-up money or the money to expand your small business; if you're looking for a small business loan, particularly one to start a business, it's definitely worth checking with your local Community Loan Fund to see if you might qualify.

Before You Apply for a Community Investment Fund

Every one of these Community Loan Funds wants to see a solid business plan as part of your application. If you don't have one, my Writing a Business Plan series that starts with the Business Plan Outline will guide you through the process of writing one.