What are business loans and how do they work?
Business loans can provide your company with essential funding, but 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
These unsecured and secured loans could help you grow your business, cover running costs or even fund a new company.
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 and repay the amount borrowed, plus interest, over a number of years.
Some of the most common types of business loans include:
Invoice finance - Borrow money against unpaid invoices to access the cash before your customer or client pays
VAT loans - Spread the cost of your VAT bill into smaller repayments
Startup loans - Borrow funds to launch a new business. Often comes with additional support but fixed eligibility terms
Asset finance - Spread the cost of equipment or machinery instead paying in full upfront
Cash flow loans - Short-term borrowing to cover gaps in income
Merchant cash advance - Receive an upfront sum and repay the loan through a percentage of your card sales
Working capital finance - Funds to cover the day-to-day expenses - such as wages or stock
Peer-to-peer loans - Borrow money from investors through an online platform - an alternative to traditional bank lending
Credit lines - Access a flexible pool of funds that you can draw from as needed and only pay interest on what you use
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 limited trading history.
Business loans can come with fixed or variable interest rates.
Fixed rates - these rates remain the same for the duration of the loan term, so you know exactly how much to budget for.
Variable rates - these rates can go up or down, depending on what is happening to interest rates in general. This can make it more 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 amounts you can borrow may be 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:
Being least 18 years old
Being able to comfortably afford the repayments
Your business being registered in the UK
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 (CCJs). This can make it more difficult to secure the loan you want.
Read more: How to improve your business credit score in 12 steps
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.
Typically, 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 with a 7.5% fixed rate of interest.
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.
Read more: Can I get a business loan without a credit check?
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
💡 Editor insight: The tried and tested financial products loved by successful businesses
FAQs
Does a business loan affect personal credit?
This partly depends on your business structure. If you’re a sole trader, you and your business are one and the same. This means you won’t have a business credit score, and lenders base their decisions on your personal credit score. If you don’t keep up with your loan repayments, this can have a negative impact on your personal credit history.
However, if your business is a limited company, there’s less direct connection between your personal and business credit scores, because the company is a separate legal entity. A business loan is therefore unlikely to impact your personal credit score.
This can change if you sign a personal guarantee that makes you personally liable for the debt if your business can’t repay it. This could affect your personal credit rating.
How long does approval for a business loan take?
This depends on the type of application, the type of business loan and the lender. Some lenders might approve your loan within an hour, while others might take a few days or even weeks.
Why was my business loan application rejected?
Business loan rejections happen for many reasons. Your business credit score could be too low, you might have made a mistake on the application form, you might have too much existing debt, or you might not meet the eligibility criteria. Whatever the reason, it’s important to find out why before applying again. It’s also best to space out any loan applications by three to six months.
What happens if I can’t repay my business loan?
If you fail to make your repayments, you could end up paying penalty fees. This can also have a negative impact on your business’s credit record. If you’ve signed a personal guarantee, you become personally responsible for repaying the debt yourself, even if this means selling your home.
If you have a secured business loan and you default on payments, the lender could take the assets used as collateral for the loan.
If you’re struggling to repay your business loan, speak to your loan provider as soon as possible. They might agree to offer a short repayment holiday or a longer-term loan with lower monthly repayments to help you get back on track.
Can I repay a business loan early?
That depends. It’s possible to repay some loans early without penalty, but others might charge a fee. That’s why it pays to read the terms and conditions carefully.
Do you get tax relief on a business loan?
Business loan repayments themselves are not tax deductible because they aren’t considered a business expense. However, you can often claim the loan’s interest as a tax-deductible business expense on your tax return.
What’s the difference between a personal and business loan?
The main difference is their purpose. You should use a personal loan for personal expenses, such as a new car or home improvements, and a business loan for business expenses.
You can typically borrow larger sums of cash with a business loan than a personal loan.
What interest rate will I pay on a business loan?
The interest rate you pay depends on various factors such as your credit profile, business finances, loan amount you need and the agreed repayment term.
Stronger applications with a good credit history and stable income are more likely to qualify for lower rates, while newer or higher-risk businesses may pay more.
Do I need to provide collateral for a business loan?
Not always. Some business loans are unsecured, which means you don’t need to offer an asset as security.
That said, if you're looking to borrow a higher amount you may need to consider a secured loan which typically requires collateral (such as property, equipment or stock). This reduces the lender’s risk and helps you access larger amounts or lower interest rates.
About Rachel Wait
Rachel has spent the majority of her career writing about personal finance for leading price comparison sites and the national press, including for the Mail on Sunday, The Observer, The Spectator, the Evening Standard, Forbes UK and The Sun.