Money is one of the biggest hurdles when starting a business and sometimes a helping hand is needed to finance rising costs or to keep a business afloat.
The most traditional way for businesses to fill funding gaps has been to take out a business loan. They allow small businesses to fund day-to-day operations or future growth.
But getting a loan can be a daunting experience because there are so many different products and providers, and confusing jargon.
We’ve put together a guide to explain what to consider before applying for a bank loan, including whether you need to take out a short-term or long-term loan and what other financing options are available.
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Check if you are eligible
The first step is to determine if you qualify for a business loan.
Each lender will have specific requirements on the turnover of companies applying and the health of the business will also be taken into account.
Most will require that your business is officially registered in the UK, the owner is over 18 and has been in business for at least six months.
You will need to decide how much you want to borrow and how long you will need it.
Decide what type of loan you need
Once you know you’re eligible, you need to figure out how much money you need, what you can afford to repay, and how long you need the money.
A short-term loan may be preferable if you need a quick cash injection to ease cash flow constraints or to purchase products or equipment.
The main advantage of short-term loans is that they are repaid quickly, often in less than a year. This limits how long interest can accrue, which means the borrower will often pay less interest overall.
They also generally have faster application processes – but the interest rate will be significantly higher than if you chose to repay the loan over a medium- or long-term period.
Medium and long-term loans usually allow you to borrow to help grow the business, which means they are spread over a long period and the monthly payments are lower.
A medium to long-term loan might be more suitable for those looking to start a business or expand their existing business.
Medium-term loans can be paid in monthly installments over one to five years, while long-term loans can range from five to 30 years. Short-term loans are usually repaid between three months and one year.
It should also be noted that it is more difficult to be approved for a long-term loan because lenders must be sure that you will be able to repay it.
It’s worth calculating monthly loan repayments before you apply so you know you can afford to pay it back.
Secured or unsecured?
Some loans are secured by an asset you own, usually your home – so if you fail to keep up with repayments, you could lose your home.
You can borrow more money with a secured loan, but it largely depends on the equity available in the asset against which the loan is secured.
Most secured loans come with upfront fees to cover administration and can be slow to get due to things like property appraisals and legal checks.
The other option is to take out an unsecured loan. This does not require an asset to be secured, but a more thorough review is applied to your personal credit history.
Get your finances in order
Once you have determined the type of loan and the amount you want to borrow, you need to make sure your finances are in order.
Debt consolidation could help. This is when you combine multiple debts into one, which can make it easier to pay off.
Lenders will review your business accounts, so make sure you have filed new accounts before applying for the loan.
You will also need to submit a detailed profit and loss account and balance sheet.
It is worth having all the documents at hand before applying, including legal documents, corporate and personal tax returns and financial statements.
You will also need to provide a clear explanation of how the funds will be used.
What are the other financing options?
You may have followed all of these steps only to find that your bank rejected your request.
Given the economic backdrop and rising costs, banks have started to tighten their stress tests on new borrowers.
Recent research from Altenburg indicates that tests that previously assumed an increase of 2% per year in a company’s cost base now assume an increase of 5% or more.
This makes the already difficult environment for small businesses even more difficult – but there are other options.
The most common short-term facility for small businesses is an overdraft, but these can be expensive, so be sure to check interest rates.
You can also usually borrow more with a business credit card than with a personal card. Some banks will allow you to spend interest-free for a set period of time, but once the 0% offer ends, the interest rate is likely to skyrocket.
>> Read our guide to the best bank accounts for small business and compare fees, interest and overdrafts.
Stress test: Banks have tightened their eligibility criteria for new commercial borrowers, taking out an overdraft or applying for a government-backed start-up loan might make more sense
You can apply for a government-backed start-up loan of £500 to £25,000 to start growing your business, and you’ll also receive 12 months of free mentorship.
Unlike a business loan, however, this is an unsecured personal loan. The loans carry a fixed interest rate of six percent per year and you can repay over a period of one to five years. The average loan size is £7,200.
Crowdfunding could be another option to raise funds. There are many platforms that allow businesses to request small amounts of money from individuals.
You will need to have a target figure, present your business details to your potential investors, and then raise the funds.
You can also raise funds through equity – when people invest for a stake in return – or through peer-to-peer lending, where money is loaned out at a set interest rate.
Former Dragons’ Den star Piers Linney told This Is Money: “If you can make equity financing work, then you’re looking at building a business that you sell or buy out from investors.”
“If you’re here, there are a lot of new platforms out there…new angel investment networks. But investors are also taking a hit in their own portfolios, so you might find that the supply of funding might drop, it will be a tough time.
“The advice should be to understand your financing options. Make sure you understand them… you didn’t just go to a high street bank and that’s it, you went home. There are lots of options.
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