What are business loans and how do they work?

Many small business owners turn to business loans to secure the funds they need to get their plans off the ground or expand into new markets. 

This comprehensive guide explains exactly how business loans work and whether you could be eligible for one. 

Key takeaways

• Business loans enable you to borrow a lump sum that you repay in monthly instalments over a set term

• You can use a business loan to pay for the costs associated with running your company

• Whether your business qualifies for a business loan depends on several factors, including the business’s credit history and financial stability

• Business loans can range from a thousand to several million pounds

What is a business loan? 

A business loan is a type of business finance that enables you to borrow funds over a set time frame. You can use the funds to support the running of your business. You then repay the amount borrowed, plus interest, over a number of years.  

Some of the most common types of business loans include:

• Invoice finance

• VAT loans

• Startup loans

• Asset finance

• Cash flow loans

• Merchant cash advance

• Working capital finance

• Peer-to-peer loans

• Credit lines

What can you use a business loan for? 

As part of the application process, you usually need to state what you plan to use the funds for. This can generally be anything you need to pay for in your business, such as:

• Startup costs

• Inventory

• Buying premises

• Hiring staff

• Equipment

• Acquiring another business

• Improving cash flow

• Expanding into new markets

• Marketing and advertising 

• Consolidating debt

• Day-to-day running costs

Note that you can’t use a business loan for personal expenses, such as the purchase of a personal car or residential property.

How does a business loan work?

When you apply for a business loan, the lender considers your business’s financial stability and creditworthiness, and how much it believes you can afford to repay, before deciding whether it’s happy to let you borrow.

Once approved, the lender transfers the lump sum to your business bank account. You then start making monthly repayments to the lender. 

Business loan interest rates

Your business loan interest rate depends on the lender’s assessment of your business risk. 

If your business has a solid trading history, good credit score and a strong track record of profitability, you’re likely to pay a lower interest rate than a business with poor credit or a limited trading history. 

Business loans can come with fixed or variable interest rates. Fixed rates remain the same for the duration of the loan term, so you know exactly how much to budget for. Variable rates, on the other hand, can go up or down, depending on what is happening to interest rates in general. This can make it difficult to work out how much you must repay over the term of the loan. 

Business loan fees

It’s important to check what fees you might pay because these depend on the lender. 

Some lenders charge an application fee to cover the costs of arranging the business loan. Others might charge late payment fees if you miss a repayment or an early repayment charge if you pay off your loan before the end of the agreed term. 

Business loan repayments

Your lender should make it clear when and how you repay your business loan.

You should be told:

• The loan amount

• The total amount you must repay

• The loan term

• The monthly repayment amount

• The due date of your repayments

• The interest rate 

• Any fees and charges 

• The penalties for late payments 

As loan repayments are usually monthly, it’s worth setting up a Direct Debit or standing order to ensure you don’t miss any instalments. 

Types of business loans

There’s a broad range of business loan types, but they generally fall into two categories – secured and unsecured.

Secured business loans

Secured business loans require you to use an asset, such as property, land or machinery, as collateral. If you fail to repay the loan, the lender can take the asset and sell it to recoup its money. 

While this makes secured loans riskier for the borrower, they are lower risk for the lender. As a result, interest rates are usually more competitive, the lend amounts are higher, and you typically have much longer to repay your loan.

Invoice finance, asset finance and bridging loans are all types of secured loans.

Unsecured business loans

Unsecured business loans let you borrow money without the need to use business assets as security. However, you may need to sign a personal guarantee, meaning you become liable for repaying the loan yourself if your business can’t. 

Because unsecured business loans are riskier for the lender, interest rates are typically higher, the lend amounts are smaller, and loan terms are shorter. 

Merchant cash advances and startup loans are examples of unsecured business loans.

Is my business eligible for a business loan?

Whether your business is eligible for a business loan depends on several factors. These vary depending on the lender, but common criteria include you being at least 18 years old and able to comfortably afford the repayments. Your business usually needs to be registered in the UK, too.

As part of the approval process, lenders examine your business credit history and, in some cases, your personal credit score – particularly if your business is new. Having a good credit score shows lenders you’ve kept up with repayments in the past, making approval for your loan more likely.

However, if you or your business has a poor credit history, this suggests you’ve had credit problems in the past, such as late payments or county court judgments. This can make it more difficult to secure the loan you want. 

How much can you borrow with a business loan?

How much you can borrow depends on the type of loan, your business’s credit history and how much the lender believes you can afford.

You could borrow up to around £750,000 with an unsecured loan and as much as £15 million with a secured loan. If you apply for a government-backed Start Up Loan, you can borrow up to £25,000.

How to apply for a business loan

You can usually apply for a business loan online, although you might also be able to apply over the phone or in branch.

When you complete the application form, you need to provide personal details, as well as information about your business. This can include your business’s address, annual turnover, and the date it started trading. 

You usually need to supply documentation such as your business bank statements, tax returns, financial projections, business plan, and proof of ID and address for you and any other owners or directors of the business. 

Business loan advantages and disadvantages

When deciding whether to take out a business loan, it’s important to weigh up the pros and cons:

Pros 

• Suitability: There are many loan types, meaning you can choose the loan that best matches your business needs

• Can help with cash flow: Applying for a business loan can help you cover expenses when times are tough

• Gives you a chance to grow your business: You can use the funds to boost business expansion

• You retain full ownership of your business: Unlike equity finance, such as angel investors or equity crowdfunding, you don’t need to give up shares in your company in return for the funds, so you retain full control

• Flexibility: You can use the funds however you like (as long as it is for business purposes) and choose how much you want to borrow and for how long

Cons

• You must meet eligibility requirements: Lenders consider your business credit score and financial stability before deciding whether to offer you a loan

• You may lose business assets: If you apply for a secured loan, your business assets are at risk if you fail to repay the loan on time

• Fees often apply: You might pay an application fee as well as early repayment charges

• Can damage your business credit score: If you miss repayments, you risk damaging your business’s credit score, which can make it more difficult to borrow money in the future 

• Lengthy application process: The application process can be time-consuming, particularly if you’re applying for a loan with a high street bank

Alternatives to business loans

If you’re still undecided about whether a business loan is the best finance option for your company, it’s worth looking at business loan alternatives. These include:

• Angel investors: These are wealthy individuals who invest their own money into your business in return for equity. They can also offer support with their time, knowledge and contacts

• Venture capitalists: Rather than investing their own money, venture capitalists raise capital from various sources and pool this into a fund. They typically invest larger sums but require a larger stake in your business in return 

• Crowdfunding: Crowdfunding enables you to get finance from the public. You pitch your business idea on an online platform and people agree to invest in return for equity or rewards. They may even send a donation

• Bootstrapping: You use your own funds to start your business, rather than relying on external funding

• Business grants: A business grant is a payment that can help you launch your business, but unlike a loan, you don’t need to repay the money. However, business grants often come with strict eligibility criteria