If you’re a small business owner, you want to give your business all the tools it needs to thrive.
But it’s hard to make financial projections when you don’t even know where your money is coming from.
This is where microloans can help. If you’re in need of financing and not sure where to start, keep reading to find out more about how a small loan can make a big difference for your business.
What are Microloans?
There’s been a lot of buzz about microloans–like how they can help lift women out of poverty. But what are they?
As the name implies, a microloan is a loan disbursed in a small amount to a business at a low interest rate.
The SBA Microloan Program
The US Small Business Administration (SBA) is one of the biggest examples of microfinancing lenders in the United States.
Their Microloan program provides loans of up to $50,000 for small businesses, startups, and nonprofit childcare facilities. The average microloan is about $13,000.
The idea is twofold.
First, the loans are designed for businesses that don’t require a lot of capital and are seeking a low-interest loan with good repayment terms.
Second, the loans fulfill a community development role by giving small businesses the capital they need to expand their offerings while attracting more business into their local community.
How Do They Work?
Many SBA loans are available through traditional financial outlets, such as banks, credit unions, and private lenders.
However, the Microloan program is unique: unlike other SBA loan programs, the Microloan program derives funding through community-based or nonprofit organizations, which makes sense when you recall that the program is designed to fulfill a community building function.
A nonprofit organization that joins as a loan provider through the SBA can receive up to $750,000 from the SBA during its first year in the program. After that, they can borrow up to $1,250,000 annually, and they act as an intermediary between small businesses and the SBA.
However, that doesn’t mean a small business can borrow $750,000 from a nonprofit through the Microloan program. They can apply for a loan of up to $50,000, with a $500 minimum. Most small businesses apply for loans between $13,000 and $14,000.
How are They Different from Regular Loans?
The biggest difference between a microloan and a regular bank loan for most small business owners is availability.
For a bank, it costs exactly the same for them to underwrite a $50,000 loan as it does to underwrite a $1 million loan.
Because of this, banks are far less likely to offer smaller loan amounts to small business owners–or, if they do, they charge much higher interest rates to make it worth the trouble.
The same thing applies to online lenders–they might offer small loans, but because the underwriting costs are the same and the payoff amount is lower, they usually tack on high interest rates and fees to make up the difference.
What Can a Microloan Be Used For?
Because banks and online lenders aren’t likely to offer microloans with user-friendly interest rates, the SBA Microloan program is usually the best option for small business owners.
However, this also means there are certain stipulations on microloans that wouldn’t apply to a normal bank loan.
Microloans can be used for a number of things, such as:
- Machinery or equipment
- Inventory and supplies
- Working capital
- Furniture, fixtures, or other office necessities
However, microloans cannot be used in two specific instances: they can’t be used to pay off pre-existing debt, and they can’t be used to purchase real estate.
The Benefits of Microloans
With all of that in mind, let’s talk about a few specific benefits of microloans.
The single biggest benefit of microloans is availability because banks and other lenders are not incentivized to offer small loans. This type of loan gives many small business owners another source. For example, a small business owner who only needed a small amount of working capital and could not afford a larger loan would not have any options if they were solely relying on bank loans.
Here are a few other benefits of microloans that might make them the right lending option for your business.
If you’re a new business and you’re just learning the ropes on, well, how to be a business, microloans can actually be a great help to you.
Under SBA guidelines, any microlender that offers loans under SBA auspices must also provide business and technical training to their borrowers.
Because of this, these microlenders often act as a kind of business counselor to their borrowers, helping them draft business plans, develop marketing strategies, and understand the technical details of how their business works so that they know what they’re getting into when they take on debt.
So, whether you’re trying to figure out how to catch up to a missed milestone or the best technology to give your business a boost, a microlender may be able to provide guidance.
Besides helping you learn how to run a better business, microloans also help businesses build (or rebuild) their credit history.
Think of it like getting your first credit card as a teenager or young adult in college.
You’ve never held a credit line before, which means that you’re an unknown risk for a lender. It’s one thing if you’re a college student and your parents or guardians can help you open an account to build credit.
It’s another thing entirely if you’re a business and you need financing but don’t have any credit history to prove that you’re a reliable borrower. Plus, if you don’t have collateral to secure a loan (like commercial real estate or accounts receivable) then you don’t have much leverage.
Microloans are designed for businesses in this situation. It’s a small loan, which makes it easier for you to pay off. And as you pay it off, your microlender reports payment experience to the credit bureaus.
This helps boost your creditworthiness in the eyes of other lenders while still getting you the funding you need to get started.
If you’ve been paying attention, you may have sensed a trend: microlenders are more forgiving to small business owners than many larger lenders.
That includes their requirements.
Unlike many large loans, microloans offer flexible guidelines for loan approvals. This is because microlenders take other factors into consideration besides your credit score, collateral, and business history.
Microlenders will require some form of credit history before giving you a loan and may include other methods to check your creditworthiness, such as personal collateral.
However, part of the beauty of this program is that the SBA is relatively hands-off. They set the cap, but otherwise, intermediaries are allowed free reign over other components of the loan.
This gives microlenders the freedom to be highly involved and personal with their borrowers–and because they have the time to get to know you, they can offer more personal solutions and terms for a loan than a large lender.
Finally, the Microloan program gives young businesses something they desperately need: the time to get the funding they need.
If you’re a new business owner, then you know that time is of the essence when you’re trying to secure capital. You may have resources now that could dissipate in the time it takes to be approved for a traditional loan–assuming you get approved at all.
Microfinance understands this, and because microlenders offer smaller loan amounts, they have the leeway to move faster than larger, traditional loans. Where it might take months to be approved for a traditional loan, microloans can be approved in as little as 14 days.
Keep in mind, though, that every lender has the freedom to set their own guidelines and standards, so it pays to do your homework before you start talking with any individual lender.
Disadvantages of Microloans
Of course, no loan is without disadvantages. The same is true of microloans.
One of the big disadvantages of microfinancing is their interest rates. Lenders tend to charge between 12-18% annual interest on these loans, depending on factors related to the borrower.
Keep in mind, though, that while these rates are high, they’re still lower than the interest rates attached to credit card loans.
The name of the loan tells you another key disadvantage. Because this type of loan is small by nature, the funds are typically insufficient for a business to fund itself from the ground up. However, if you truly need a larger loan amount, then microloans probably aren’t the best option for you anyway.
Does it sound like a microloan might be the right fit for your business? If so, let’s talk about your chances of qualifying for a loan.
As previously noted, beyond the loan cap, the SBA grants microlenders free reign when it comes to managing the details of their loans. As such, eligibility requirements often vary between lenders.
That said, there are some factors in common.
Technically, all small businesses and nonprofits are eligible to apply for the SBA Microloan program. However, due to the size of the loans, the Microloan program is best suited to small, home-owned businesses, the self-employed, and nonprofit daycare centers.
Regardless of the type of business, all applicants should have at least two years of industry experience and must be able to demonstrate sufficient income to repay the loan.
While credit score requirements vary, businesses should have at least a 640 to be considered a good candidate.
Different lenders may be flexible, though, so it’s important to talk to your local nonprofit lender about your options. Personal credit scores as low as 575 have been approved, but you will need to explain any undesirable entries on your credit report.
Terms and Interest Rates
Before you apply, you’re probably also thinking about the terms and interest rates attached to your loan.
Again, the SBA offers lenders leeway in deciding how to set their terms. Your interest rate and the terms of your loan will be affected by:
- The total amount of the loan
- The proposed use of funding
- Requirements set by the intermediary
- Your needs as a borrower
In general, interest rates are usually between 8-13%, and the maximum repayment term allowed by the SBA is six years.
Applying for a Microloan
Do you think you’re ready to apply? If so, here are a few things to keep in mind.
Items to Prepare in Advance
Before you begin, you’ll need to get in touch with an SBA intermediary in your area. Any financial institution with whom you have a relationship is usually able to offer recommendations on this front.
Once you get in touch with your intermediary, they will provide you with all of their requirements for a loan. However, it’s helpful to have these things prepared:
- Business plan
- Any applicable business licenses and permits
- Financial projections
- Balance sheets
- Profit and loss statements
- Personal financial statements
- Business and personal income tax returns at least two years back
Note that this list is not comprehensive–it simply addresses some of the most common documents that lenders require.
The Application Process
Once you’ve selected a lender and found out their requirements, it’s time to begin the application process.
Your lender will tell you everything they need to determine whether you qualify for a loan. The first step of the process is assembling all of the documents they ask for. Some lenders will require certain workshops, classes, or training programs as part of the application process, but this varies between lenders.
Once you’ve submitted your materials, the lender will review them and determine whether you’re a suitable candidate for a loan. Some lenders approve applications in as little as two weeks, but the average approval time is between 30 and 90 days.
Need More Tips to Help Your Business Soar?
Microloans can help your business get started, but you need more than financing to stand out from the crowd.
That’s where we come in.
For more tips and resources to help you get your business off the ground, check out our other articles, like this guide to working capital loans.