What is the best small business loan for you?
Identify What You Can Afford
At the beginning of your loan serach, one of the first questions lenders will ask you when you start your small business loan search is “How much are you looking for?”
Yes, we would all love a cool $5 million. But instead of thinking of this question as how much you want or need, think along the lines of what you can actually afford. If you don’t know the answer to that question, follow the steps below.
Calculate Your Debt Service Coverage
The best way to determine the small business loan payments your business can afford is to calculate your debt service coverage ratio. This is the number lenders will use to see how much cash you have to service your debt. This is also a number YOU can use to make sure you are comfortable with any potential debt payment. Your debt service coverage ratio is simply:
Cash Flow (sales-expenditures) / Loan Payment (principal+interest) = DSCR
You can calculate this on a monthly or annual basis.
All lenders are going to want to see that you have a DSCR of at least 1, because if you don’t, where are you getting the cash to pay them back?
Decide now. Let’s say it’s 2. Now, take your current monthly cash flow, divide it by 2, and use that number as you shop. Aim to find a loan that will allow your total monthly loan payment to be equivalent to that amount.
Download our DSCR calculator to the right!
Perform a Small Business Loan Performance Analysis
It is important to remember that the reason you are taking out a small business loan is to invest in your business. Before taking on the debt, you need to make sure that you will in fact have a return on this investment.
Can you safely say that this debt will grow your business?
It’s not an easy question to answer, so a great thing to do before committing to a loan is forecasting loan performance. By running a loan performance analysis, you can see how this small business loan will financially impact your business. It is also a great way to ensure you aren’t taking out too large (or too small!) of a loan.
loan performance analysis
Write Down Your Ideal Loan Payment
Now that you’ve taken a look at how small business loans can financially impact your business, and how to calculate your debt coverage ratio, decide on a rough estimate of a total monthly loan payment you’d be comfortable with. Keep this number close as you start your search.
debt coverage ratio
The Role Credit Plays in Small Business Loans
Believe it or not, your personal credit score is one of the most important parts of the small business loan application. The way lenders see it is that they are lending money to the small business OWNER, so they want to ensure that you’ve got a strong history of acting wisely when someone has given you “credit.” The better your credit score, the better your chances of your securing an affordable small business loan.
A great thing to do before you apply for a small business loan is to pull your own credit report and check your credit score. You can do so for free at annualcreditreport.com. Be wary of any other site that makes you pay! By pulling your credit report, you now know exactly what lenders will be looking at.
Analyzing Your Credit
The first thing you need to do is check your report for errors. There could be things on your report that aren’t correct or even applicable to you that are bringing down your score. This could be things like:
- Erroneous accounts or credit lines you never opened
- Erroneous judgments or collections
- Accounts, judgments or collections that were satisfied but are still showing as outstanding
- udgments or collections you never knew about
To get this information removed, you need to first verify that the information is in fact erroneous. If it’s a collections matter, you could start by tracking down the collection agency and asking them to let the credit bureaus know you’ve satisfied the debt. Or, if it is an unknown outstanding debt, pay it off and then ask the agency to contact the bureaus. For other matters, contact the credit bureaus directly. Send a dispute letter along with the supporting documents needed to verify the claim. The credit bureaus are obligated to investigate these matters and will usually get back to you with a result in around 30 days.
If you don’t find errors on your report, but you think you can stand to improve your credit history, try to identify the areas where it needs the most work.
As you can see, your payment history has the biggest impact on your FICO score. The best place to start improving your score is to make sure you’re paying all your bills on time!
If you’re curious what credit score you need to apply for a loan, that’s a tough one to answer. For online lenders, you’re going to want to have credit score over 550, but you will receive better offers if your credit score is higher, say over 620 or preferably 640.
If you think you can improve your score, it may be worth it to take the steps to do so and wait a few months before applying.
Here are a few steps you can take to improve your credit score within the next year.
What Financials Will Lenders Ask for During the Small Business Loan Application?
Small business loans can have pretty extensive applications – depending on the loan product you are applying for. Generally speaking, the lower the cost of the loan and the longer the term of the loan, the more paperwork that will be involved. But, no one lender is alike and each will have their own set of requirements. Here’s an idea of some of the most popular documents needed for small business loan applications. Keep in mind — this is only a portion of what many lenders will ask for!
Business Bank Statements
Bank statements are a document you will almost always be expected to provide. For some lenders, you may just need 3 months. Others may ask for 6 or 12 months. Some will even ask for 2 years. Be prepared to pull whatever history length the lender asks for.
Many lenders will want to see your balance sheets or “statements of financial position.” They will most likely want to see a balance sheet that has been updated within 60 days. This is to give the lender a “snapshot” of the company’s recent financial health.
You can download a balance sheet template here.
Profit and Loss Statement(s)
Many lenders will want to see your Profit and Loss Statements, also known as your Income Statements. They will most likely want to see your P&Ls from the last two fiscal years (also shown on business tax returns), as well as a company prepared Year-to-Date (YTD) version that has been updated within 60 days. This is primarily to determine the cash flow of the business and if it is able to meet existing and proposed debt obligations.
You can find a profit and loss statement template here.
Business Debt Schedule
Some lenders are going to want to know if you currently have business debt and if you do, the payment details of that debt. To do this, they will ask for a debt schedule. This helps the lender determine your current debt obligations and if your cash flow is able to meet existing and proposed debt obligations.
Find out more about debt schedules here.
Personal Tax Return
Most lenders will want to see your most recent personal tax return to verify your income. If you haven’t filed your taxes for this year, it might be best to do so before you apply, or at least have your extension paperwork readily available.
Business Tax Return
Most lenders will want to see your business tax returns from the last two fiscal years. If you haven’t filed your taxes for this year, it might be best to do so before you apply. Lenders will use your business tax return to verify revenue, among other things. If you are a sole prop or LLC who doesn’t file a separate business tax return then don’t fret! Lenders will just want to see the forms and paperwork tied to your business, like a Schedule C, on your personal tax returns.
Read more about what lenders care about on your tax return here.
Calculating the True Cost of Small Business Loans
When you are shopping small business loans, it can be very difficult to compare the various products on an apples-to-apples basis. Why? Many lenders advertise the cost in “interest rates” but, truth be told, this doesn’t offer a full representation of the price of the product. So, how can you compare products?
Ask lenders for the APR
APR stands for Annual Percentage Rate. It is probably a term you are familiar with if you use a credit card. It represents the cost of a loan by including the interest rate AND any other fees you will incur to take on the loan. You may think you’re getting a killer interest rate from a lender, but if they have a ton of hidden fees, they may not be the most affordable option. That’s why APR is so important – it lets you compare loans across the board. APR can sometimes be difficult to calculate, so it is best to use an APR calculator.
Know What Fees to Watch For
Now that you know fees affect APR, you’re probably wondering what type of small business loan fees we’re talking about. Here’s a cheat sheet of fees you need to watch for with small business loans:
An origination fee directly reflects the cost lenders incur to make a loan (think administrative work, etc.) It is often quoted as a percent of the principal.
Since it costs money to run credit and background checks, as well invest the time to underwrite a loan, some lenders will charge you a processing/application fee to recoup that cost upfront, or wait until the loan is closed.
If you’re considering an SBA loan, there is a chance you might have to pay a guarantee fee. Why? The SBA doesn’t directly make small business loans. Instead, they guarantee portions of loans, making it less risky for lenders to make loans to small business. But, to do this, lenders must pay a portion of the guaranteed amount to the government, so they often pass this fee directly on to the borrower.
Late Payment Fee
Probably not much of a surprise here, but with some lenders, if you’re late on a payment, they’ll charge you a fee. If they aren’t automatically drafting from your account, be sure you’ve got a good internal reminder system in place so you never forget a payment!
Considering paying your loan off early? Better be sure the lender doesn’t have a pre-payment penalty! This fee is usually calculated as a percent of the outstanding principal at the time you decide to pay it off. Many lenders do this to ensure they recoup their costs from underwriting/servicing the loan.
Check Processing Fee
Many borrowers make their payments through ACH. If you prefer to send your payment in with a check, some lenders may charge you to process it. It is very important to discuss payment methods with lenders before signing on the dotted line.
Choose Your Small Business Loan
You’ve done a lot of hard work to get this far! Now it is time to make the call. Ask yourself:
- Can I repay this loan?
- Am I comfortable with the payment, whether it is daily, weekly, or monthly?
- Can I confidently say this is the lowest rate I will find?
- Do I know all potential fees associated with the loan?