A small business loan is money borrowed from a financial institution by an entrepreneur to start, run, or expand a small business. While it might sound simple in theory to stop by your bank or credit union and fill out a small business loan application, the reality is that over four in five small business owners are denied financing from banks big and small by 2020 estimates. Further, 40% of applicants for the Paycheck Protection Program and 90% of applicants for the Economic Injury Disaster Loan program have yet to receive their loan proceeds.
The difficulty in getting approved for a loan stems from a variety of unique challenges facing small business owners that go beyond the prevailing economic climate. With just a little insight, though, you can identify the unique issues that make it hard to get a small business loan, ways to overcome them, and alternative sources of funding to successfully finance your venture.
The Challenges Small Businesses Face With Loans
Small businesses are more likely to confront the following financial and operational issues than their larger counterparts:
- Lack of collateral: Collateral is personal or business property ranging from real estate to equipment. It’s required for secured business loans, including many Small Business Administration (SBA) loans, as it serves as a secondary form of payment for a loan in the event of loan default. But new business owners who don’t yet have business infrastructure may have to use their personal home as collateral, which can be risky.
If you use your personal property as collateral for a loan and later default, you risk losing it because it can be sold to repay your debt to the lender.
- Poor or insufficient credit: Lenders typically look at the credit lines and past payment history in your personal and business credit reports when making lending decisions in order to determine your creditworthiness or likelihood of repaying your loan on time. Small business owners with insufficient business credit history are more reliant on their personal credit reports, and if they contain negative items, entrepreneurs will have an even harder time proving their creditworthiness and getting approved.
- Large debt or low income: In addition to credit, a lender may look at your income to determine your capacity to service your debt. Fledgling businesses that are overburdened by expenses and haven't yet secured a steady income may have a harder time proving that they have the capacity to repay their loan.
- Insufficient capital investment: Lenders view applicants more favorably if they have a reasonable amount of capital invested in the business but can still finance their debt. A cash-strapped small business that is overly reliant on outside funding and hasn't invested much of its own money in the firm doesn't have enough "skin in the game" in the eyes of lenders, which is viewed as a negative.
- High small business loan application failure rate: Big banks approved only 13.6% of small business loan applications in Aug. 2020, according to a survey from Biz2Credit. While small banks fared better, at 18.5%, the slim odds of approval are a barrier to entry for the average small business owner.
How to Address Small Business Loan Challenges
Increase your odds of approval by following these strategies:
- Create a small business plan with your application
- Secure collateral
- Improve your credit before loan application
- Maximize your income and minimize your debts
- Make moderate investments in your small business
Create a Small Business Plan for Your Application
A business plan is a document that outlines your company, products, target market, staffing, and projected financial statements, including the cash flow statement, profit-and-loss statement, and balance sheet. The plan should be included with your small business loan application.
Lenders scrutinize business plans to ensure that the business they plan to lend to is likely to succeed. If you have a business plan that demonstrates a solid business model backed by sound management, your small business loan application will be more difficult to deny.
A strong business plan can in some cases avoid the need to put up collateral to secure your loan.
If you seek a secured loan but don't have personal or business property, you may want to wait until you own tangible assets, such as houses or other property, before you apply for a small business loan.
If you have property you're willing to use as collateral, take an inventory of your property and determine what you're willing to put up as collateral in light of the risk of losing it in the event of loan default. Then, prepare a collateral document that details the specific personal or business property you will use to secure the loan, along with its value.
If you're unwilling to put up collateral, consider loan programs that don't require it. For example, SBA 7(a) and Express loans don't require collateral for loans up to $25,000. Similarly, unsecured loans, by definition, don't require collateral to secure the loan.
Improve Your Credit Before Loan Application
Assess your credit by obtaining a copy of your personal credit reports from the three credit bureaus, which you can do free annually under federal law. If you have negative items such as late payments, resolve them before you apply to improve your odds of approval. If you're already in business, lenders will evaluate your business credit, so similarly obtain and review your business credit reports for negative items. You can do so for free from companies such as Dun & Bradstreet or Nav.
Beyond clearing up negative items, bolster your credit by opening credit cards or other forms of credit, making timely payments, and keeping your balances low.
Maximize Income and Minimize Debt
Your debt-to-income ratio compares your monthly debt (including your potential loan expenses) to your monthly gross and demonstrates to lenders whether you bring in enough income to repay your debt. The optimal debt-to-income ratio varies by lender, but aim for 36% or less to improve your odds of loan approval.
To reduce your ratio, increase your gross monthly income (by increasing sales volume or prices, for example), increase the amount you pay in debt each month, and delay large, non-essential purchases.
Make Moderate Investments in Your Small Business
Lenders use your debt-to-equity ratio to determine how much you seek in financing relative to how much you've already invested in the business. Aim for a ratio of 1–1.5 to show lenders that you've invested a reasonable amount in your business but still have the ability to repay debt.
As your business grows and sales increase, add assets to reinvest a portion of your earnings back into the business and pay down debt to boost equity and maintain an optimal debt-to-income ratio.
Credit Unions vs. Banks
Banks have traditionally been the main provider of credit to small firms. Roughly 68% of small businesses that obtain traditional sources of credit such as loans get it from a commercial bank; another 5.5% get it from a savings bank or savings or loan association.
However, credit unions have become a more reliable source of financing for small businesses in the era following the Great Recession, extending it to 3.9% of those who obtain traditional forms of credit according to Federal Reserve data from 2017. Importantly, credit unions approved small business loan applications at a rate of 21.1% in 2019, which was higher than that of either big or small banks, according to the Biz2Credit study.
One reason for this is that banks have gotten larger and more national (and international) through mergers and acquisitions, and the larger the institution, the less likely decisions (such as lending policies) are made at the local level. The broader access to credit markets that larger firms have has also meant that larger banks have shifted focus to lending to larger firms and have loaned money to small firms at lower rates. Credit unions are smaller, more locally oriented institutions, and as such, are more likely to lend to small businesses in their communities.
Other Small Business Loan Options and Opportunities
Alternatives to consider if you can't get a traditional small business loan include:
- Community investment funds
- Term loans
- Lines of credit
Community Investment Funds
Community Investment Funds (CIF) are typically nonprofit organizations that get their working capital from local communities and invest in business ventures in those communities. They're dedicated to helping individuals who can't get the loans they need from a traditional lending institution (such as a bank or credit union) either because they work in a location or niche where they're underserved by banks or they can't satisfy the requirements of these institutions.
Examples include the Boston Impact Fund, which focuses on lending to local social-justice-oriented businesses, and the Runway Project, which extends loans to entrepreneurs of color in Oakland, California. If you have a low income or poor or no credit history, lack collateral, or you're young or a new immigrant, your local CIF may be willing to grant you a small business loan. While application requirements vary, these funds typically require you to be based locally, represent the demographic or work in the business niche the fund serves, and have a solid business plan.
Terms loans are fixed-rate loans extended in the form of a lump sum that you repay over a term of up five years through predictable monthly payments that are easy to budget for. You can use these loans to pay for equipment, machinery, and other business essentials.
These loans are available from banks and credit unions as well as alternate sources like online lenders. Lenders will typically look at your credit, business track record, and financial statements when making an approval decision.
Small Business Lines of Credit
A line of credit is a flexible loan with a preset borrowing limit. You can use it like you would a credit card: Tap the line of credit up to the limit when the need arises in order to access cash for business expenses. Interest accrues on the amount you borrow, and when you repay what you borrowed, the funds become available again. It's a great way to cover gaps in your cash flow.
You can get a line of credit from a bank, credit union, or alternate lender; most banks require you to have been a business owner for a certain period of time to qualify for one. As you make payments on time, you can build your credit profile to the point that you can obtain a traditional loan.