Bank Loans and Lines of Credit for Small Business

Term Loans vs. Lines of Credit

These are the two most common bank products for small businesses, and they serve very different purposes.

Term Loans

A term loan gives you a lump sum of money that you repay on a fixed schedule over a set period, usually one to ten years. Interest can be fixed or variable. Term loans are best for specific, one-time investments: buying equipment, purchasing a vehicle, renovating a space, or acquiring another business.

Lines of Credit

A business line of credit gives you access to a pool of money you can draw from as needed, up to your approved limit. You only pay interest on the amount you have drawn. As you repay, the available credit replenishes. Lines of credit are best for managing cash flow gaps, covering seasonal expenses, or handling unexpected costs.

How Banks Evaluate Your Application

Banks use a framework often called the "Five Cs of Credit" to assess your loan application:

1. Character

This is your personal credit history and track record. Banks look at your personal credit score (typically wanting 680 or above), your history of managing debt, and whether you have any bankruptcies, liens, or judgments. For existing businesses, they also look at your business credit profile.

2. Capacity

Can you afford the payments? Banks analyze your debt service coverage ratio (DSCR), which is your net operating income divided by your total annual debt obligations. Most banks want a DSCR of at least 1.25, meaning you earn $1.25 for every $1 you owe in debt payments.

3. Capital

How much of your own money is in the business? Banks want to see that you have skin in the game. For most business loans, expect to put up 10% to 30% of the project cost as a down payment or equity contribution.

4. Collateral

What assets can you pledge to secure the loan? Equipment, real estate, inventory, and accounts receivable can all serve as collateral. If you default, the bank has something to recover. For unsecured lines of credit, you typically need a stronger financial profile.

5. Conditions

What are you using the money for, and what is the state of your industry and the overall economy? Banks are more likely to lend for clear, revenue-generating purposes than for speculative ventures.

What You Need to Apply

For most bank loans or lines of credit, prepare the following:

• Two to three years of business tax returns
• Two to three years of personal tax returns for all owners with 20%+ ownership
• Year-to-date profit and loss statement
• Balance sheet
• Accounts receivable and accounts payable aging reports
• Business bank statements (last three to six months)
• Business plan or loan purpose statement
• Personal financial statement for each major owner

Improving Your Chances of Approval

Build the Relationship Before You Need It

Open your business checking account at the bank where you plan to apply for a loan. Use their merchant services. Deposit consistently. Banks lend to businesses they know. A 12-month banking relationship can make the difference between approval and denial.

Clean Up Your Personal Credit

Your personal credit score matters enormously, especially for businesses under $1 million in revenue. Six months before you plan to apply, pull your credit report. Dispute any errors. Pay down revolving balances to below 30% of your limits. Do not open new personal credit accounts.

Get Your Books in Order

Banks do not trust handwritten ledgers or shoebox accounting. Use accounting software. Have your books reviewed or compiled by a CPA if possible. Clean, professional financials signal that you run a serious operation.

Show Consistent Revenue

Banks love predictability. If your revenue has been growing steadily for two to three years, you are an attractive borrower. If your revenue is lumpy or declining, address that in your application with a clear explanation and a plan.

Start Small

If you have never borrowed from a bank, start with a small line of credit, maybe $25,000 to $50,000. Use it, repay it, and build a track record. Then go back for a larger facility when you need it.

Interest Rates and Fees to Watch

• Interest rate: Can be fixed or variable. Variable rates are tied to the prime rate or SOFR. Ask what index the rate is based on and what the margin is.
• Origination fee: Typically 0.5% to 2% of the loan amount, charged upfront.
• Annual fee: Some lines of credit charge an annual maintenance fee, whether you use the line or not.
• Prepayment penalty: Some term loans penalize you for paying early. Ask about this before signing.
• Draw fee: Some lines of credit charge a small fee each time you draw funds.

When to Choose a Bank Loan Over Alternatives

Bank loans and lines of credit offer the lowest interest rates and the most favorable terms. But they also have the strictest qualification requirements and the longest approval timelines. Choose a bank when:

• You have been in business for at least two years
• Your personal credit score is above 680
• You can document consistent, growing revenue
• You have time to wait 30 to 60 days for approval
• You want the lowest cost of capital available

If you cannot meet these criteria today, consider alternative lenders or SBA loans as a bridge while you strengthen your banking profile. The goal is always to graduate to bank financing because it is the cheapest money available.