What's covered in this guide?
This comprehensive guide will take you through what you need to know when choosing a business loan. Here we’ll cover the A-Z of business loans, including:
- The difference between debt and equity finance
- When to consider getting a business loan
- Types of business loans
- The difference between secured and unsecured finance
- Interest rates and terms of business loans
- Choosing between a fixed and variable interest rate loan
- Business loan requirements
- Factors that determine how much you can borrow
- How to calculate the cost of a loan
- The length of time required to get approval for various types of loans
- Determining which business loan is best for you.
Debt or equity finance – what’s right for your business?
Debt finance includes any type of finance where you are expected to pay the funds back. This includes traditional bank term loans and alternative forms of business finance. Examples of debt finance include secured and unsecured business loans, credit cards, business overdrafts, lines of credit, and loans from family and friends. If you’re unfamiliar with any of these, we’ll cover them in this guide.
With equity finance, you don’t have to repay any money but you give up part of the ownership of your business. Forms of equity finance include private and public (share market) investors, family and friends, angel investors and crowd-sourced funding. This guide focuses on debt finance, so we won’t cover any of these forms of equity finance in this guide.
In addition, most small-to-medium enterprises choose debt finance to get established and grow. Equity finance is often considered at later stages after a business is well established and has achieved significant growth. When the company has a proven track record, it’s more likely to attract investors who see the potential for future growth and want an equity share in the business.
When is the right time to get a business loan?
If you have a new business or have been operating for a few years, you will inevitably ask ‘When is the right time to get a business loan?’ For some, there is a stigma attached to getting into debt with a business loan. If you have personal debt, getting a business loan might seem like a step backwards. However, most businesses need to get finance at some point to overcome cash flow issues or take steps to expand. Here are a few reasons why it might be time to get a business loan:
One of the most common reasons for getting a business loan is to improve cash flow. Your business might be making enough sales but lacks working capital when profits are tied up in receivables and inventory. If you know that money from outstanding invoices will come in and that you will continue to make enough sales, a business loan can help you get through times when cash flow is tight. For example, if you have a seasonal business with a proven track record, you might consider getting a business loan to buy inventory in preparation for the busy season. After you sell the products, you can repay the loan.
Another example is a manufacturing business that produces and sells products to its distributors. The business needs to buy material and pay for labour and the overheads of production. The lag time between spending the money on production and getting paid by distributors can be several months. In this situation, the lack of cash flow could be solved with a short-term loan.
There are times when a business will need funds to grow. For example, if you are in manufacturing and win a new contract that requires expansion, you will need to acquire plant and equipment and hire new staff before the funds come in from the increased production. In situations like these, a business loan will give you the cash you need to expand to meet customer demand.
When you have been a business for a while, you will know what products or services are most popular and what’s most profitable. Although you might not have the cash on hand, you could see an opportunity to buy inventory that’s in demand. In this situation, a business loan will help you make the purchase and realise the profit from increased sales. If you sell seasonal products, a business loan will enable you to buy inventory to get ready for your busy times.
Capital goods such as machinery and equipment have a high cost but produce income for the business over an extended period. In most cases, you won’t be able to self-finance or make a large purchase for cash. When you need machinery or equipment that’s essential to operate, a business loan could be the answer. The company supplying the machinery or equipment might offer finance as well. If you decide to take up this finance from the supplier, you are in effect getting a business loan. When purchasing machinery and equipment, getting the right business loan can help you grow without harming your cash flow.
Effective marketing and advertising can be the key to growing your business. With a range of digital channels available to market your business, you can start small to determine what’s most effective for generating leads and sales. Once you know what works, you can start a larger marketing campaign. If you have big plans for promoting your business, a business loan will provide the funds you need to make it happen.
If successful, the money spent on advertising will generate more sales. In return, the additional sales can contribute to repaying the loan. After you pay other variable expenses, the increase in sales represents profit for your business.
When a business is successful, relocation might be necessary to enable continued growth. You might be in a service business where you are hiring new staff and running out of office space. Or you could have a retail shop that’s not big enough for all the stock you want to offer. Whatever the reason, relocating can be expensive, so it’s most likely you will need a business loan to relocate.
If you are in retail and successful in one location, the next step for growth could be expanding to a new location. This will require money, and a business loan could be the way to get the funds you need to expand to a new location.
Your business may need renovation for functional reasons, you might have a retail location that needs to be refreshed or you it could be time for a new office fit-out. Whatever the reason, a business loan will give you the funds to make it happen.
As your business grows, you will need to hire and train staff. In most situations, there will be a lag between the time when staff are hired and when they contribute to the bottom line. If formal training is needed, this adds to the cost. For these reasons, a business loan can make it possible to hire and train new staff so you can grow.
There will come a time when a business needs to get some form of business loan to expand or overcome a challenge. If you start with a business loan and successfully pay it off, you will build credit for the future when your finance needs could be larger. When the time comes to get the bigger business loan, you will have a proven track record from your previous activity.
You might have outstanding debt that you want to pay off with a business loan. For example, having ATO debt makes it difficult to get other forms of finance, such as a bank loan. Also, you might have other debts such as credit cards that you want to consolidate. A business loan will enable you to do this.
Types of business loans
Once you have decided that it’s the right time for a business loan, you will need to choose between a range of business loan options. Here we’ll look at some of the loans available.
This is what comes to mind when most people think of a business loan from a bank. With a bank term loan, you will need to complete a lot of paperwork. Besides the application, you will be required to provide financial statements and possibly a business plan. Being a secured loan (requiring collateral), the interest rate will be lower. As a term loan, you will have a regular monthly payment. The main drawback of a traditional bank loan is the time it takes to get approved, which can be up to two months. Another challenge is that banks in Australia reject 74% of small businesses that apply for these types of loans (DFA SME Report).
Business credit cards are a popular form of small business finance. Although the interest rates can be high for business credit cards, most offer an interest-free period (usually 55 days) on charges. So if you pay off the amount within 55 days of the charge, you don’t pay any interest. When applying for a business credit card, the provider will want basic details such as income and length of time in business. They will also check your credit report and score to determine your creditworthiness. Sometimes, business owners use personal credit cards for business finances. This can be a simpler form of business finance if it’s not possible to get a business credit card. However, it’s a good idea to keep your business and personal finances separate, so this option can bring some challenges with it.
With a business overdraft, you are allowed to run a negative balance on your regular transaction account up to a predetermined amount. You pay interest on any funds that are overdrawn from your account. In addition to the interest on funds used, you will be charged fees. These include an establishment fee and a regular accounting fee. Business overdrafts are available in secured and unsecured forms, with different interest rates reflecting varying levels of risk to the lender.
With a business line of credit, you get approved to borrow an agreed amount but only pay interest on what you use. For example, if your bank approves a line of credit for $100,000 and you only use $50,000, you will only pay interest on the $50,000 you are using. This gives you the flexibility to use the money only when you need it. You can also repay the loan at your own pace. Business lines of credit usually start at a $50,000 minimum, so if you are looking to borrow a lower amount, a business line of credit won’t be an option for you.
A business equity loan can be in the form of a loan or line of credit which is secured against residential or commercial property. Several advantages of a business equity loan are that you can borrow up to 100% of the value of a residential property used as security for the loan and get a competitive interest rate. The biggest shortcoming of this type of loan is that your property is at risk if you get into financial difficulties and cannot make the payments.
If you don’t have financial statements and proof of income for the previous two years, a low-doc loan could be the solution. If you can’t provide proof of income, a no-doc loan might be suitable for meeting your business finance needs. Low-doc and no-doc loans are backed by residential property. The main drawback of these loans is higher interest rates due to the increased risk to the lender. Low-doc and no-doc business loans are usually provided by specialist non-bank lenders such as Liberty. Approval times for these types of loans can vary from a few days to weeks.
These types of business loans are growing in popularity due to the ease and speed of getting them. Some fintech lenders specialise in helping small-to-medium businesses get the finance they need without having to go through a complicated lending process. When applying for an unsecured online business loan, the lender safely and securely analyses your finances, including banking transactions, along with other information to determine how much you can borrow. Compared to many other business loans, the process is quick and straightforward.
If you don’t want to wait to receive money from your customer invoices, you can work with an invoice finance company to receive the funds sooner. When you create an invoice, you ‘sell’ it to an invoice finance company. They pay you a percentage of the total invoice value (80% to 95%) immediately and charge an advance fee (usually between 2% and 5%) of the invoice amount. When the customer pays the invoice, you get the remaining funds, minus any fees and charges.
Choosing between secured and unsecured business finance
When considering your options, it’s important to understand the basic difference between secured and unsecured loans. Simply put, a secured loan is backed by collateral that has been pledged by the borrower. With an unsecured loan, you don’t pledge collateral. Depending on the type of the loan, collateral for a secured loan can include residential, rural or commercial property, machinery, equipment and vehicles.
Even if a loan is not secured, meaning you haven’t pledged specific collateral as security, your assets can ultimately be used to repay the outstanding balance if you are not able to make repayments.
What’s the difference between interest rates of secured and unsecured business loans?
Whether a loan is secured or unsecured has a large impact on determining the interest rates. This is because the risk will be higher for the lender with an unsecured business loan. With a secured business loan, you pledge property or other assets that the lender can sell to repay the loan if you are are not able to make repayments. This decreases the risk for the lender, so secured business loans have lower interest rates compared to unsecured business loans.
For example, the interest rate for one secured business overdraft is around 8%, while the interest rate for an unsecured overdraft from the same bank is around 12%.
Besides the difference between secured or unsecured business loans, different types of business loans have different interest rates. Let’s look at a few examples of these business loans and their interest rates.
Interest rates on various business loans
The interest rates on this type of business loan can range from around 5% to 12% per cent per annum. With a line of credit, the lender agrees to provide funds up to a predetermined amount. You can draw funds at any time but only pay interest on what you are using from the line of credit. For example, if you have a $50,000 line of credit but have only drawn $25,000 from the total, you only pay interest on the $25,000.
Businesses that don’t want to wait to receive funds from customer invoices can work with an invoice finance company to receive the funds sooner. When you generate an invoice, you ‘sell’ it to an invoice finance company. They pay you a percentage of the value (80% to 95%) immediately and charge an advance fee (usually between 2% and 5%) of the total amount. When the invoice gets paid, you get the remaining funds, minus any fees and charges.
Although the interest rate for invoice finance might seem low, at between 2 and 5 per cent, remember that this is the rate for a short timeframe – which would be the time it takes for the customer to pay the invoice. For example, if the customer pays the invoice in two months, and you are charged 3% for receiving the payment immediately from the invoice finance company, you are paying 18% interest on an annual basis. So compared to other business loans, the annual interest rates for invoice finance can be high.
With a merchant cash advance, you borrow funds and repay them through the ongoing credit card and EFTPOS sales of your business. When you are paid by customers, the lender gets a small percentage of all your credit card and EFTPOS sales until the amount owed is repaid. Interest rates on merchant cash advances vary but are usually around 20% per annum.
Equipment finance is a specialised form of lending to purchase machinery and equipment. With this type of loan, you own the asset immediately and the equipment or machinery is used as security for the finance. With an equipment finance loan, you make regular repayments for equipment over the term of the loan – usually three to five years. The interest rates for these types of business loans can range from 6% to 15%.
Business credit cards are a popular option for short-term funding needs. Compared to other types of business loans, interest rates on credit cards can be high – ranging from 6% to 22%. Many types of business credit cards are available, depending on your requirements. Those offering more features, such as frequent flyer points and buyer rewards, will have a larger annual fee. Many credit cards offer an interest-free period (usually 55 days on purchases), so a credit card is often a good option if you pay it off each month.
This is the traditional type of business loan where you complete a large amount of paperwork and go through a long approval process – which can take up to two months in some instances. With the rigorous approval process and using assets as security, the interest rates can be competitive compared to other business loans, starting at around 5%. The biggest downside with a traditional business loan is that many small to medium enterprises are not successful in getting approval. Research shows that Australian banks reject around 75% of small businesses seeking a traditional secured bank loan. This is because banks are bound by regulatory limitations which make them unable to lend to many SMEs.
Online lenders use leading-edge technology to analyse the financials of businesses requesting loans. This includes looking at recent bank account transactions along with a credit report to determine the ability to repay the business loan. Interest rates on unsecured online business loans start at around 18%. Although the interest rates are higher, these are usually short-term business loans, so the overall interest paid can be less than with a long-term business loan with a lower interest rate.
|Type of Loan||Secured or Unsecured||Interest Rate* (per annum)|
|Line of Credit||Secured or Unsecured||5% to 12%|
|Business Overdraft||Secured or Unsecured||7% to 12%|
|Merchant Cash Advance||Secured||20%+|
|Equipment Finance||Secured||6% to 15%|
|Business Credit Cards||Unsecured||12% to 22%|
|Invoice Finance||Secured||12% to 36%|
|Bank Term Loan||Secured||5%+|
|Unsecured Online Loan||Unsecured||25%+|
* These rates are based on information found on websites of banks, non-bank lenders and finance brokers when this guide was created. Interest rates are subject to change.
Choosing between fixed and variable interest rate business loan
In addition to secured or unsecured, you also have the choice of a fixed or variable rate interest. Both have advantages and disadvantages. With a fixed rate, you know what you will be charged over the term of the loan and have predictable payments. With a variable interest rate, your payments could change over the life of the loan. If you have a short-term business loan and you don’t think the interest rate will rise, the variable rate will probably be better for you. On the other hand, if you have a long-term loan and you expect that the interest rate will increase, it could be better to lock in with a fixed-rate loan.
Business loan requirements – what you need when applying for a business loan
Many business owners have asked, “What do you need to get a business loan?” To answer this question, we will examine several requirements you will need to fulfil when applying for a traditional bank loan. Although all of these won’t be required for all loans, it will give you an idea of some of the things you will need for the various business loans available.
Before you apply for a business loan
Before you approach a lender, you will want to cover a few things:
- Amount and use of funds – before you speak with a lender, you will need a clear picture of how much money you need and what you will use it for. Even if you’re not starting a new business, you might want to create a business plan for this purpose. Conduct research to support your numbers. If you need a piece of machinery for a manufacturing business, for example, get quotes from companies that supply this machinery. Remember to include all costs. In the machinery example, this would include delivery and installation.
- Credit report – a lender will view your credit report, so it’s a good idea to know where you stand before asking for a business loan. Any late payments, defaults and judgements will make it difficult to get a business loan. You can get your credit report for free. Learn more about your credit report and credit score, and where to get yours.
- ATO tax debt – if you are in a payment arrangement with the ATO, you are less likely to be approved for a business loan from a bank. Before entering a payment arrangement with the ATO, discuss your ATO debt with potential lenders to find out if this will prevent you from getting a business loan.
- Collateral for a secured loan – if you are seeking a secured loan, consider what you will pledge as collateral. Loan security can include residential, commercial or rural property, and business assets. If you plan to use property as collateral, make sure you know what it’s approximately worth and what you owe on it.
Business loan requirements for bank loans
- Identification – when applying for a business loan, the bank will need to know who you are, including researching your background. For these reasons, having your ID – driver’s licence, passport, or both – is the first step in meeting business loan requirements.
- Financial statements – there are four types of financial statements (Balance Sheet, Income Statement, Cash Flow Statement and Statement of Retained Earnings). In seeking a business loan, a bank will usually want to see the first three of these which show your assets, liabilities and net worth. In addition, you may be asked for other documents such as your most recent tax returns and business activity statements (BAS).
- Proof of personal income – you will probably need to provide your two most recent tax returns and notices of assessment if you are a shareholder and/or director in a company.
- Bank statements – the lender will want to see your latest business bank account statements either in hard copy or electronic format. Also, any other statements showing assets and liabilities, such as business savings and credit cards, will be required when seeking a business loan.
- Business plan – a business plan is a common requirement for start-ups and new businesses seeking a business loan. Writing a business plan will require substantial time and research. Find out what’s typically included in a business plan.
Remember that this list is based on the stringent requirements when seeking a traditional bank loan. Other types of business loans will have different requirements that include some, but not all, of the items listed above.
How much can you borrow with a business loan?
If you are thinking about taking out a business loan, one of your first questions might be ‘How much can I borrow when getting a business loan?’ Banks and other lenders use several factors when considering how much they will lend to you and on what terms. Here we’ll examine some of the factors that lenders take into account when deciding on how much to lend.
Generally, the types of question banks will ask fall into two categories: qualitative and financial-based. Qualitative questions include whether you have had a default or judgement against your business. Financial-based data includes the numbers behind your business, such as your net profit and existing debt.
Qualitative factors about your business
How long have you been in business?
Many businesses fail in the first few years, so longevity counts. From the bank’s perspective, the longer a company has been in business, the less risky it is to lend to. Of course, it needs to be financially stable and meet other criteria, no matter how long it has been in business.
What’s the purpose of the loan?
This will influence the lender’s decision and how much they will lend. If the purpose is to improve cash flow, the lender will want to know about the company’s financial position and why it is having challenges with cash flow. If it’s a result of seasonal fluctuations, then the lender will assess the risk. If the loan is to buy machinery and equipment, this is less risky as the lender will be able to claim the asset if the debt cannot be paid. Before applying for a loan, you will need to have a clear idea of what the money will be used for and be ready to explain it to the lender.
How is your credit history?
This is a big one for lenders. They will look at your credit history for late payments, defaults judgements and any other negative information. You will want to check your credit report and score before applying for a bank loan. Go over your credit report to ensure all the information is correct. If there’s information on the report that’s incorrect, you will want to contact the credit reporting agency to rectify the matter. For example, a credit card company could have incorrectly reported a late payment which shows on your credit report. First, discuss this with the credit reporting agency. If that doesn’t work, call the credit card company to clear up the issue.
Do you have outstanding tax debt?
Having tax debt or a payment plan with the ATO will limit your business loan options. If you have an ATO debt, and you want a bank loan, you will have to pay the tax debt off first. Some online lenders, such as Moula, offer loans to pay tax debt.
Is the loan secured or unsecured?
A secured loan has collateral attached to it. If a business defaults on a secured loan, the lender can use the collateral to repay the amount owed. Given that there is less risk with a secured loan, banks tend to lend more at a lower interest rate when the loan is secured.
Your financial numbers
Some of the things lenders will consider when determining how much to lend are net profit after tax and depreciation per annum. Your net profit is your sales revenue after all operating expenses, taxes and interest. This number will give lenders a general idea about how well the business is doing in generating sales and managing expenses. Lists of industry averages are available so lenders can see how well your business is doing compared to others in your industry.
Depreciation allocates the cost of an asset over its useful life. Depreciation is viewed as an expense, so if you this is a large number it could decrease the amount of credit offered to you.
These are what you take out of the business and include owner drawings, retained earnings and dividends. The more that is taken out of the business, the less is available to cover costs. So higher distributions from the company can mean a smaller business loan amount for the borrower.
This includes any current or potential debts as follows:
- Loan repayments per month – this is the total amount you are currently paying for other debts. The higher amount of loan repayments, the less you will be able to borrow.
- Lease or hire purchase repayments per month – as with other loans, this will affect your ability to take out other loans and how much you can borrow.
- Business credit card limits – even though you might not be using your credit cards, the limit represents the potential to take on more debt. So the higher your credit card limits, the less you will be able to borrow.
- Business overdraft limits – as with credit cards, your potential amount of debt will influence how much you can borrow.
When seeking a traditional term loan from a bank and asking, ‘How much can I borrow?’, remember that you will be required to provide a large amount of documentation. This will include:
- Financial Statements (Balance Sheet, Income Statement, Cash Flow Statement and Statement of Retained Earnings)
- Bank Statements
- A Business Plan – usually for a new business.
After you have submitted all your information, it could take up to two months to get a decision on whether the business loan has been approved.
With unsecured online business loans from Moula, the application takes around 10 minutes to complete and you will get an answer in under 24 hours. This is possible because Moula uses leading-edge technology to safely and securely analyse the financial data of each business applying for a loan. If the loan is approved, the funds are transferred immediately to the bank account of the business.
Business loan terms – from short-term to long-term business loans
Another factor to consider when selecting a business loan is the term, which is the length of the loan. These can vary greatly between loans. In general, the shorter the term, the higher the interest rate. For example, a traditional secured bank term loan will have an interest rate of around 5%. In contrast, an online business loan with a two-year term will have a higher interest rate. As we explained earlier, the interest rate on a business loan is influenced by whether the loan is secured or unsecured.
The loan term should be taken into consideration when choosing a business loan. If you need funds to cover short-term cash flow needs, a short-term loan could be the answer. If the loan is to be used to purchase commercial property for your business or high-cost machinery, a long-term loan would be more suitable. The term of your loan will also be determined by your ability to make repayments. If you want to borrow a large amount, you probably don’t want a short-term loan as the payments could be too high for you to make regularly.
How to calculate the cost of a business loan
Several components go into the cost of a business loan, including fees and interest.
The principal on a loan is the amount you borrow. For example, if you are getting a business loan for $100,000, the principal is $100,000. If the loan was interest-free (which occurs sometimes with government loans for disaster relief), you would owe $100,000 over the term of the loan. If the term of this loan was 10 years with annual payments, you would be required to pay $10,000 per year. If payments were on a monthly basis, they would be $833.33 per month ($100,000 ÷ 120 months) on the interest-free loan.
What is interest?
Interest is what you are charged for the use of the money. For example, if your interest rate is 10% and your loan is $100,000, the annual interest is $10,000. This is a simplified example that shows the simple interest rate.
What is compounding?
Compounding is the result of the fact that the principal is constantly accruing interest. As a result, you are paying for interest on top of interest. In our loan example of $100,000 over 10 years at 10%, monthly compounding means you are paying more interest over the life of the loan. In this example, the monthly payments would be $1,321.51, the total interest payable over 10 years would be $58,581, and total payments would be $158,581.
What is APR?
If you compound interest daily, the interest rate in the previous example is actually 10.041%. This is known as APR (annual percentage rate) which considers compounding when being calculated. If you add a $1,000 set-up fee to the loan, the annual percentage rate grows to 10.281%. This amount is often called the ‘comparison rate’ because it enables you to get a true comparison of the cost of various loans by adding in fees. In this example, we used daily compounding, but compounding can be on a weekly, fortnightly or monthly basis as well depending on the loan.
Before you take out a business loan, be sure to check all the details, including how the fees and interest are calculated. A loan that appears to have a lower interest rate can actually have a higher comparison rate due to the added fees.
Compare business loans with SMART Box™
In early 2019, a loan comparison tool was introduced to enable you to quickly and easily compare business loans. Learn more about SMART Box™ and how it can help you compare business loans.
Length of time needed for approval for various business loans
The time it takes to get approved for certain types of loans will vary greatly between lenders. Here are a few estimates for getting types of loans based on the information provided by lenders.
- Traditional bank term loan – with all the paperwork required a traditional bank term loan can take some time – from a few weeks to two months
- Hire purchase – used to purchase vehicles and equipment, this loan can take from one to two weeks to get approved
- Business credit card – these can be fairly quick to get if you meet all the criteria, taking two to seven days
- Bank overdraft – if you have a good track record with your bank, it can take one to two days to get approved for a bank overdraft
- Online unsecured business loan – fintechs (financial technology companies) use state-of-the-art technology to analyse the finances of potential borrowers. This makes it possible to approve business loans within 24 hours.
|Type of loan||Timeframe for approval|
|Bank term loan||2 weeks to 2 months|
|Hire purchase||1 to 2 weeks|
|Business credit card||2 to 7 days|
|Bank overdraft||1 to 2 days|
|Unsecured business loan||24 hours|
Determining which business loan is best for you
Now that you know about the various types of business loans and features, you are better prepared to choose the right type of business loan for your needs.
To wrap up, here are a few points to keep in mind:
- Get a clear picture of how much you need and how you will use the funds – this is a good starting point that will help you determine which type of loan is best for you. If you are unclear about how much you need, you will want to create some cash flow projections based on possible future scenarios.
- Compare all aspects of business loans – as we have seen, business loans come in many forms. To fully understand what you are getting into, make sure you understand the fees, interest rates, terms and conditions.