Lending (also known as "financing") occurs when someone allows another person to borrow something. Money, property, or another asset is given by the lender to the borrower, with the expectation that the borrower will either return the asset or repay the lender. In other words, the lender gives a loan, which creates a debt that the borrower must settle.
Review examples of the types of lending, how businesses are treated differently than individuals by lenders, and what to consider before seeking a business loan.
What Is Lending?
Simply put, lending allows someone else to borrow something. In terms of business and finance, lending often occurs in the context of taking out a loan. A lender gives a loan to an entity, which is then expected to repay their debt. Lending can also involve property or another asset, which is eventually returned or paid for in its entirety.
Lending dates back to at least ancient Mesopotamia when agricultural communities would borrow seeds and animals with the promise to repay once the crops were harvested or the animals gave birth. In modern society, lending occurs whenever someone swipes a credit card to buy a cup of coffee, takes out a mortgage to buy a home, or uses student loans to attend a university.
How Lending Works
Lending occurs whenever a lender gives something to a borrower on credit. It's a broad term that encapsulates many different kinds of transactions.
Common lenders include financial institutions, such as banks and credit unions, that build a business model around lending money. The borrower pays a price for taking out the loan in the form of interest. If the lender feels there's a higher risk of not being paid back by a borrower, like with a new startup business, they will charge that borrower a higher interest rate. Lower-risk borrowers pay lower interest rates.
Lenders do not participate in your business in the same way as shareholders, owners, or partners. In other words, a lender has no ownership in your business.
Lenders have a different kind of risk from business owners/shareholders. They also have different rights if the company goes bankrupt. A business being liquidated must pay lenders back before the owners receive any money.
Types of Lending
Lending can be broadly broken down into two categories: personal (or "consumer") lending and business lending. Some types of loans are available in both personal and business lending, though they are handled differently.
For example, an individual can get a personal credit card to buy groceries and other basics, and a business can get a business credit card to buy equipment and other business expenses.
Differences Between Consumer Lending and Business Lending
From a borrower's perspective, there are some legal protections with personal loans that aren't extended to borrowers with business loans.
The Equal Credit Opportunity Act and the Fair Housing Act protects U.S. borrowers from discrimination. The general protections from discrimination extend to all forms of credit, whether it's a personal loan or a business loan. However, the specific regulations of the Equal Credit Opportunity Act become more relaxed for business loans—the bigger the business entity, the fewer restrictions on their loans. The restrictions that get relaxed have less to do with discrimination and more to do with what kind of notifications the lender must give the borrower, and how long the lender must retain certain records on the borrower.
The Fair Housing Act, on the other hand, doesn't explicitly distinguish between consumer loans and business loans.
Types of Loans
Business lending can help all different kinds of businesses. Some common uses for business loans include:
- Loans to even out cash flow ("working capital loans")
- Commercial and industrial loans (which require collateral) for short-term needs
- Asset financing for equipment and machinery or business vehicles
- Credit card financing
- Vendor financing (through trade credit) from suppliers
As you shop around for a business loan, consider these factors:
- The amount of money you want to borrow, which will influence the type of lender that you need
- Any business assets you can pledge as collateral for the loan, which will help improve the terms of the loan
- What you want to do with the loan, which could affect the type of loan you seek (such as a mortgage for land or buildings)
- Whether you need a startup loan to start a business or an expansion loan to help grow an existing business
- How long you need the money, which will affect the type of loan and lender that best fits your needs
Types of Lenders
The most common lenders are banks, credit unions, and other traditional financial institutions. However, there are many other types of lenders, including:
- Peer-to-peer (P2P) lenders
- Crowdfunding contributors
- Family and friends
P2P lenders can operate through online organizations, like LendingClub. These sites connect lenders with borrowers. P2P interest rates may be lower than borrowers would find with a traditional bank, but higher than a lender could receive from a certificate of deposit.
Crowdfunding sites like Kickstarter are similar to P2P lending sites, in that they digitally connect the people who need money with the people who have money. Unlike P2P lending, the people who contribute to crowdfunding efforts may not receive their money back dollar-for-dollar. Instead, they may receive perks from the person or project being funded. For example, someone may donate to a movie project's Kickstarter, and in return, they'll receive a copy of the movie once it's completed.
Family and friends can become lenders, and these transactions are sometimes called "private party loans." It's important to consider the impact a loan might have on your personal relationship with these people. A loan agreement may help ensure everyone is on the same page.
If you have the means, you can loan your own money to your business, as an alternative to investing in it. If you choose to loan yourself money, write a contract that specifically spells out your role as a lender, the payment schedule, and the consequences for defaulting on payments.
As you look for a lender, consider the type of loan you need, whether you have any assets to pledge against the loan, and the other factors that will determine your ability to get a business loan and the terms of that loan. Be prepared with a personal financial statement, a business plan, and financial statements for your business.
Small business owners might also consider contacting the Small Business Administration (SBA). The SBA works with lenders to provide guarantees for loans to small businesses. Their 7(a) loan program helps small businesses get loans who might not otherwise qualify because of "weaknesses" in their applications.
The SBA doesn't act as a lender. Instead, a lender makes the loan and the SBA will guarantee the loan by agreeing to repay up to 85% of the loss in case of default. The SBA's 7(a) Small Loan, for example, allows you to borrow up to $350,000 with up to 75% of that $350,000 guaranteed by the SBA.
- Lending takes place when a lender allows a borrower to borrow something.
- Lending typically occurs in the form of loans.
- Banks and credit unions are the most common lenders, but there are a wide variety of options for potential borrowers.