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How Do Business Loans Work?

Sukanya Mukherjee -

Whether you have products or services to sell or just love being your own boss, you'll need to set up a business to take your idea forward. But setting up a business comes with plenty of teething troubles. Most importantly, you will need a good amount of capital to get your business up and running. Thankfully, a variety of business loans are available to help solve this monetary issue and shape your dream.

What is a business loan?

Business loans are forms of capital provided by different lenders to businesses. In exchange for this capital, lenders levy the repayment of the principal amount with interest added to it. Also, the borrowers need to make the regular repayment on a set timeframe.

Types of business loans and how they work

There are several types of business loans that an entrepreneur can take to meet his/her financial goals.

1. Term loan

Any loan with a defined tenure and a set schedule of repayment is called a term loan. It is one of the most common kinds of loan used for both personal and professional uses. A term loan is a fixed amount to be repaid in regular payments over a defined schedule. The amount that an entrepreneur can take under this loan varies depending on the business credit history. There are two types of term loans:

  • Short-term loan: The tenure of a short-term loan is typically between 12 months and 60 months.
  • Long-term loan: The tenure of a long-term loan is typically between 10 years and 30 years.

2. Start-up loan

New enterprises often opt for start-up loans. Such applicants may not have a good business credit history. In such cases, lenders ṣconsider the borrower's personal credit history to determine the eligibility of the enterprise. The applicant also typically needs to submit the proof of business registration to avail a start-up loan. The loan amount, interest rate and tenure of this loan vary depending on the business’ current turnover and other financial strengths.

3. Working capital loan

Entrepreneurs take working capital loans to fund the everyday expenses of a business. Working capital loans help a company deal with cash shortages and the cash needed to pay for raw materials, rent, electricity bills and other utilities. This loan also helps the entrepreneurs fulfil demand during peak seasons, and tackle the cash flow crunch during off-seasons.

In a working capital loan, the bank charges interest only on the utilised amount, not on the entire sanctioned amount. Also, banks keep checking the business’ monetary health in a regular and audited manner.

Hence, working capital loans are good for those who don’t enjoy stable income throughout the year. Service providers, wholesalers, retailers, manufacturers, or traders involved in the export/import business can be the ideal candidates for this type of loan.

4. Overdraft loans

Overdraft loans are based on some form of security or collateral, often a Fixed Deposit (FD). Before approving a certain fixed overdraft limit, the bank analyses the applicant’s credit history, repayment history, tenure of the banking relationship, cash flows, and then determines whether a person is eligible to get the loan. Based on the sanctioned limit, the borrower can withdraw the required amount and pay certain interest applicable on the utilised amount only. The entrepreneur can use this loan amount for any purpose, provided that he/she repays the principal and the interest as per the decided term.

5. Equipment or machinery loan

Entrepreneurs take equipment loans to buy new equipment needed to run their businesses smoothly. Purchased equipment is taken as collateral, along with some other form of security. Manufacturing units, which may require expensive equipment for the smooth operation of their business, often take equipment loans. Interest rates on this type of loan are often lower than for term deposits.

6. Business credit card

Banks provide different types of business credit cards to meet the financial needs of small and mid-sized businesses. While a business credit card is not a business loan, entrepreneurs can use it to finance their businesses. A business credit card is a great choice for short-term or immediate funding needs. Business owners can use this card to build business credit and also earn attractive rewards, introductory cash-back, etc., on their purchases. So if you wish to avail fast cash and look to get some great rewards at the same time, a business credit card may be right for you.

7. Merchant cash advance

If you have a poor credit history or need some fast cash that you wish to repay with a part of your daily debit card sales or your business credit, the merchant cash advance may be the right choice for you. The big benefit of this type of loan is that the borrower has to repay the loan amount as per his/her daily sales. So, if your business is running slow, the repay amount will also be low. If your business is reaping good profits, you can repay a higher amount, which may mean that it can turn into an expensive option.

How to apply for a business loan?

If you are wondering how to get a business loan or how a business loan works, you should first understand how much of a loan your business requires and what is the purpose of that loan. Also, before you apply for a business loan, set yourself up to be a good applicant. Do your taxes regularly, maintain a good credit score, build a good relationship with lending organisations, and upgrade your financial knowledge. If you prove to be eligible for these criteria, you are ready to get a business loan.

Since almost all financial institutions and banks offer business loans, you can easily apply online to avail a business loan. Ensure you have looked into the type of loan that will best suit your specific needs. Then evaluate your eligibility, prepare essential documents, and apply online. To apply online, visit the bank’s official website, fill out the loan application form, submit the necessary documents and wait for the approvals. If you are eligible to get the business loan, you will get it soon.

Eligibility criteria

Eligibility criteria significantly vary between lenders, but some common ones are

  • Applicant age – The age of an applicant should be between 25 to 55 years.
  • Business tenor – Business tenor should not be less than 3 years.
  • Credit History – The applicant should have a good credit score or an established credit history.

Documents required to apply for a business loan

  • Proof of identity - Driving license, PAN card, Passport, Voter ID, etc.
  • Proof of address - Electricity bill, trade license, ration card, etc.
  • Bank statements
  • Audited financial statements for the last three years
  • Latest Income Tax certificate

Top 6 banks that offer business loans in India

  • ICICI Bank
  • HDFC Bank
  • Kotak Bank
  • Federal Bank
  • Bank of Baroda
  • State Bank of India

Conclusion

Every type of business loan has its unique set of terms and conditions, features and principles. Irrespective of which type of business loan you apply for, you will need to fulfil some criteria to qualify and get approved. So, depending on the nature of your business, credit score, available collateral, financial health, and your time in business, you can apply for a certain type of loan to meet your financial goals. It is advisable to choose a business loan that can best match your business profile, purposes, and requirement. Also, once you get a loan, ensure that you repay it on time, so that it may help grow rather than hurt your venture. Getting a business loan becomes a lot easier when you know all your options and have done your due diligence.

Also read:

1) What is Home Loan? A Complete Guide.
2) How does No Cost EMI work?
3) What is the Difference Between Secured & Unsecured Loans?
4) What is Business Loan? A Complete Guide.