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How do business loans work?

Written By:
Myles Robinson - Expert Finance Advisor

Posted: Jan 4, 2023

Fact Checked By:
David Nicholson - Finance Editor

How do business loans work?

A business loan can help you get business finance to grow your business.

Learn how business loans work, and how you can get the right business loan to suit your needs.

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What’s a business loan and how do they work?

Business loans, also known as business finance as the name implies, are for business use only and can be extended from a few weeks up to many years.

Loan providers offer an unsecured business loan and a secured business loan.

The process of business loans is the same as that for personal loans. A lender will approve your application for a certain amount, typically a bank or building society.

If they do, they will determine if they are willing to lend you money and, if so at what interest rate. To have a personal loan you must have a good personal credit score, to apply for a business loan you must have a good business credit score.

You can accept or decline their offer and you will be paid the entire amount. The loan amount plus interest rates will be due over the life of the loan and you will have to repay it in monthly installments.

Lenders will vary in the specific business loans they offer, but generally, they are for between £1,000 to £50,000. The amount you can borrow will depend upon many factors such as the size of your company and its financial health. Small business loans are also available on the market.

Failure to make your monthly repayments could result in you being charged a penalty fee for late or missed payments, or even losing any assets you have secured the loan.

Read more: Business Loans vs Personal Loans

What types of business loans are there?

There are many types of business loans, but they can all be described broadly as either unsecured loans or secured loans.

Unsecured Loans

Unsecured loans allow you to borrow money without a business asset, which is any property or machinery that can be used as security.

Secured loans

How do business loans work? Secured loans require you to pledge an asset, such as stock, machinery, or property, as security. The lender can seize the business assets if you fail to pay the loan agreement payments on time or fall behind in repayments.

Unsecured loans are not secured by an asset so they will have a higher interest rate. This means that the amount you repay will be greater than a secured loan.

An unsecured loan has the advantage that you don’t have to lose your home or any important machinery if the loan is not repaid.

What government-backed loans for businesses are available?

You might have difficulty borrowing from traditional lenders if your business is a new start-up. This is because you don’t have a lot of financial history and you are unlikely to be making any profit. You can instead apply for a Start-Up Loan from the government.

For what purpose are business loans used?

Before deciding to lend, the lender will likely want to know how the loan will be used. It is important to remember that business loans can’t be used for personal purposes, such as buying a car for the family or going on vacation.

Although there are many reasons businesses may need to borrow money for business purposes, these are the most common:


You can use this money to buy new stock or equipment, pay off bad debts, or tide over a business during low seasons.

Asset Purchase

You might have to borrow money to pay for large purchases that are difficult to cover with your daily cash reserves.

Property prices

A short-term or long-term loan could help you pay for property costs, whether it’s a large deposit on business premises or a bridge loan to cover your expenses during a move.

Long-term financing

These large investments can be costly and take time to increase revenue.

Which loan is right for me?

It is crucial to choose the right loan for your business. There are many factors to consider before you decide on the right loan for your business. These factors include:

How much do you want to borrow

It can take a long time to apply for a loan. This is not something you want to do multiple times. Calculate the cost of the project and add a contingency fund in case it increases.

Remember that interest will be charged on the entire loan amount. If you borrow more than you need, you may end up paying unnecessary fees.

What you can afford to pay each month

This will affect how much and how long you wish to borrow. While you pay less interest, your monthly payments will be higher if you borrow over a longer-term. When calculating your monthly repayments, make sure to include the interest and any fees.

You can choose between a fixed and variable interest rate

Fixed-rate loans are those where the interest rates are fixed for the term of the loan. Variable-rate loans allow the interest rate to change depending on the Bank of England’s base rate.

Fixed-rate loans will let you know how much you’ll be paying each month. This will make it easier to plan your expenses in advance. You could lose out on savings if interest rates drop. You can also rest assured that your interest rates will not change if they go down.

Variable-rate loans can be beneficial because they allow you to benefit from lower interest rates. However, your monthly payments will likely increase if the interest rates rise.

Additional fees and restrictions

It is important to understand the type of loan that you are applying for. Are there any fees such as application or administration fees? If you repay your loan early, are there late repayment fees? Are you able to borrow additional money, extend your loan term or modify your loan repayments? Or is the loan fixed? Compare the various loans offered by different lenders.

There are many reasons to take out a business loan

With the goal of using borrowed capital to grow their business, small businesses often take out commercial bank loans. Small businesses may be able to use inventories or receivables as collateral for small business loans.

Borrowing money can be very expensive depending on where it originated. There are also fees and interest that come with almost every loan.

Before accepting a loan, businesses should be able to calculate the total interest they will have to pay over the life of the loan.

Here are four reasons why a business loan is worth taking on.

Existing firms looking to buy real estate for expansion will likely be offered money by banks. If a company is making a profit and has a growing cash flow, and can forecast the future, the expansion will usually occur.

This scenario is what makes it more likely that a bank will approve a small-business loan.

A mortgage is the most common form of bank loan for real estate.

Bank loans for the long term will be secured by company assets and require quarterly or monthly payments of profits or cash flow.

The repayment of the loan will be subject to an interest rate and can last from 3 to 25 years.

To Buy Equipment

There are two options for businesses when it comes to purchasing equipment. They can either lease or buy it. A business owner can depreciate equipment over its life span if they borrow money.

If the equipment is no longer in use or outdated, it can be sold at salvage value. To determine whether to purchase or lease equipment, a cost-benefit analysis must be done.

A bank will usually lend equipment to a company for the short term.

The loan is typically repaid monthly and lasts less than three years. The equipment’s useful life will usually be the determinant of when the repayment is due.

To Purchase Inventory

Small businesses that have a good relationship with banks may be eligible for short-term loans that are repaid in one year.

Trust can be built by making timely payments and maintaining a positive balance in your checking or savings account. Small businesses such as hospitality, retail and agriculture are often seasonal.

A short-term loan can be used to purchase inventory ahead of time if a company is able to make most of its holiday sales. Most bank loans used to purchase inventory are short-term.

Companies plan to repay them after the season ends using profits from seasonal sales.

To increase working capital

Working capital refers to the money that is used to run the day-to-day operations of a business.

Small business loans may be taken out by small businesses to cover operational expenses until they reach a certain amount of earnings. A bank loan is a short-term option for businesses that have good credit and a solid plan.

Because they are considered riskier than real estate loans, working capital loans have a higher rate of interest than real estate loans. If the business is not managed well or the earnings assets cease to be profitable, it will go bankrupt.

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