Types of Business Loans Explained: From Lines of Credit to Term Loans

Having adequate access to capital is often the lifeblood of growing companies. It is what enables growth, innovation, and stability. But to many entrepreneurs and business owners, business loans are intimidating and confusing, riddled with industry lingo and what seems like an endless array of options.

Demystifying the landscape around commercial bank services is therefore a must, including the different types of business loans available. From flexible lines of credit for ongoing operational needs to structured term loans for long-term investments, and specialized financing solutions, there are numerous options available. But what does each option mean and which is best suited for your business?

The Core Categories: Debt vs. Equity & Secured vs. Unsecured

Before getting into particular loan types, let us first describe the basic differences in business lending. The very first of these differences is between debt financing and equity financing.

Debt financing is borrowing money to be repaid within an amount of time, with or without interest. The primary advantage here is the business is able to retain full ownership with no dilution. Equity financing is issuing a portion of ownership of the company to investors in exchange for capital. While this is not repaid and reduces financial risk to the business, it does dilute the ownership of the founders/owners.

The second significant differentiation is secured vs. unsecured loans.

A secured loan will require the borrower to pledge collateral – tangible assets such as real estate, equipment, inventory, or accounts receivable – for the loan. This collateral reduces the risk to the lender, usually resulting in improved terms for the borrower, such as lower interest rates.

Conversely, an unsecured loan does not incorporate collateral. As the lender takes on a higher risk without anything to sell in case of default, unsecured loans are typically charged higher interest rates and possess more stringent conditions of qualification, generally requiring excellent creditworthiness and strong cash flow projections.

Common Business Loan Types for Diverse Needs

Firms have a wide spectrum of financing needs, and luckily enough, there is a wide range of loan types to suit them.

Term Loans

A term loan is pretty much the most straightforward type of business loan. It involves a single, lump sum of money borrowed at a time, which is then repaid over a fixed period, typically with regular, pre-set interest payments.

These sort of loans are ideally suited for major capital expenditures, such as purchasing expensive equipment, acquiring commercial real estate etc.

The pros of term loans include highly predictable monthly payments, often with the option of a fixed interest rate, which simplifies budgeting, and their suitability for substantial, long-term investments. However, the cons include their relative inflexibility (once set), and these often require a strong credit history and/or substantial collateral.

Lines of Credit

In contrast to the lump-sum nature of term loans, a line of credit offers unparalleled flexibility, acting as a revolving credit facility. A business is approved to borrow up to a set limit, and it can then draw, repay, and re-borrow funds as needed, much like a business credit card.

Interest is only charged on the actual amount taken, not the full credit limit. This makes lines of credit perfect for financing cash flow gaps, bridging the gap between the time when customers are billed and money is paid, taking advantage of seasonal changes in inventory, or financing unexpected operating expenses.

Their main strengths are high liquidity and flexibility the benefit of paying only interest on borrowed money, and quick access to capital. Their disadvantages are usually variable interest rates, and a need for good business credit.

SBA Loans

SBA loans are government supported commercial loans designed to help small businesses get funding they might not otherwise get. That said, SBA Loans are not directly issued by the U.S. Small Business Administration. Instead these are partially guaranteed by the SBA and then issued by traditional lenders such as banks and credit unions. The government backing reduces the risk for lenders, making capital more accessible to small businesses that might not otherwise qualify.

These loans have a wide use case - from covering startup costs and providing working capital to financing equipment, real estate purchases, and even debt refinancing.

The pros of SBA loans are highly attractive: typically lower down payments, longer repayment terms (reducing monthly payments), and very competitive interest rates. However, the cons include a very lengthy application process, strict eligibility criteria, and a significant amount of paperwork.

Equipment Financing

Equipment financing is a form of loan designed specifically for businesses looking to acquire necessary machinery, vehicles, technology, or office equipment. Its distinctive feature is that equipment itself serves as collateral against the loan. This makes it a popular choice for sectors needing heavy equipment or state-of-the-art technology.

The main benefits are that it conserves working capital, as you don't have to advance cash for the equipment. It typically has easier approval due to the secured nature of the asset, and allows tailored terms that can align with the useful life of the equipment. Disadvantages are that the equipment depreciates over time, and the financing may not cover "soft costs" like installation or training.

Commercial Real Estate Loans

For businesses looking to own their physical premises, commercial real estate loans are the go-to solution. Commercial real estate loans are used to purchase, develop, or refinance commercial properties, including office, retail spaces, industrial warehouses, or mixed-use developments.

Their use cases are clear: buying premises for your business operations, acquiring properties for investment purposes, or funding new construction projects.

The pros typically include very long repayment terms (typically 15-25 years), the potential for appreciation in property over time, and the ability to accumulate equity in a valuable asset. The cons include huge down payments (typically 10-30% or more), a notoriously lengthy and complex approval process, and complex paperwork.

Invoice Factoring/Financing

Invoice factoring or financing offers a unique way for businesses to unlock cash tied up in their outstanding invoices. With factoring, a business sells its invoices to a third-party factor at a discount, receiving immediate cash.

The factor then collects the payment directly from the customer. With invoice financing, the business borrows against its invoices, with the invoices serving as collateral. These solutions are ideal for businesses with long payment terms (e.g., 30, 60, or 90 days) or those experiencing cash flow gaps due to slow-paying customers.

The key pros include quick access to cash and a significant improvement in immediate cash flow. For factoring, it's technically not a traditional loan, so it doesn't add debt to the balance sheet. However, the cons are typically high fees (calculated as a percentage of the invoice value), the potential to impact customer relationships if the factor handles collections directly, and the inherent lender involvement in your receivables process.

Niche & Specialized Loan Types

Besides the more general business loan types, there are several niche and specialty loan types for special financial situations or business structures. Some of them are:

• Merchant Cash Advance (MCA): Short-term, high-cost funding option that is only suitable for businesses needing immediate cash and with stable, steady credit card revenue.

• Startup Loans: Intended for new businesses, hard to qualify for, and more credit-dependent on the founder.

• Working Capital Loans: Short-term loans tailored to cover a company's day-to-day working capital expenses and cover short-term liquidity gaps.

• Bridge Loans: Short-term lending applied to cover critical needs; a bridging measure for an expected eventual capital event.

• Franchise Loans: Tailored funding option for franchise purchases; less complicated than general startup loans for a new firm.

Conclusion

Navigating the business loan landscape means understanding that there is no universal "best" loan. Instead, the most suitable funding solution always depends on the specific context of your business. Diverse options, like term loans or lines of credit, and specialized solutions like equipment financing or invoice factoring, each serve distinct purposes.

Understand the subtleties of each loan type to make truly informed decisions and secure the most appropriate loan aligned with your business needs. Businesses may consult with financial advisors and diligently explore multiple loan options before committing.