What is a business loan and how does it work?

As a small business owner launching a new café, I’ve been researching funding options but feel overwhelmed by financial jargon. Could you please explain what a business loan actually is in simple terms? I’m particularly confused about how these loans function—what the application process involves, how lenders decide eligibility, what terms like interest rates and repayment schedules mean, and whether collateral is always required. Also, how do traditional bank loans differ from online lenders or SBA loans, and what documentation should I prepare when applying? Since I’m projecting initial revenue gaps before becoming profitable, clarity on these mechanics would help me assess if this is the right funding route versus other alternatives like investors.

A business loan is a sum of money provided by a financial institution or lender to a business entity, which must be repaid with interest over a predetermined period. It serves as a common financing option for companies to cover operational costs, expand operations, purchase equipment, manage cash flow, or fund new projects.

How It Works:

1. Application: The business submits a loan application, including financial statements, business plans, credit history, and details about the loan purpose and amount.
2. Lender Assessment: The lender evaluates the business’s creditworthiness, repayment capacity, collateral (if any), and industry risks. This involves reviewing credit scores, cash flow projections, and business stability.
3. Loan Agreement: Upon approval, both parties sign a contract outlining terms: loan amount, interest rate (fixed or variable), repayment schedule, duration, fees (origination, prepayment, etc.), and collateral requirements.
4. Funding: The lender disburses funds, often as a lump sum or in installments, depending on the loan type and terms.
5. Repayment: The business repays the principal plus interest through scheduled payments (e.g., monthly installments). Payments may include both principal and interest (amortizing) or interest-only during an initial period. Collateral can be seized if defaults occur.
6. Completion: Once repaid, the loan is closed. Credit scores may improve with timely payments, enhancing future borrowing opportunities.

Key Components:

• Principal: The initial loan amount borrowed.
• Interest Cost: The expense charged by the lender, expressed as an annual percentage rate (APR).
• Collateral: Assets pledged to secure the loan (e.g., real estate, equipment), reducing lender risk.
• Repayment Term: The timeframe for repayment, typically 1–25 years, aligned with the loan’s use (e.g., short-term for working capital, long-term for real estate).
• Covenants: Conditions borrowers must meet, such as maintaining minimum financial ratios or insurance.

Common Loan Types:

• Term Loans: Potlump sum repaid in installments over a fixed term.
• Lines of Credit: Flexible access to funds, drawn and repaid as needed.
• SBA Loans: Government-backed loans (e.g., 7(a) or 504) with favorable terms.
• Equipment Financing: Loans specifically for purchasing equipment, with the equipment as collateral.
• Invoice Financing: Advance payment based on outstanding invoices.

Requirements: Businesses typically need strong credit, consistent revenue, and a solid operational history. Startups may provide personal guarantees, and lenders may require business plans or financial projections.

Business loans enable growth by providing capital without diluting ownership, but they create debt obligations and incur interest costs. Successful repayment builds credit, while default may damage finances or collateral.