How Business Loans Work: A Plain-English Guide

The five main types

1. Term loan

Borrow a lump sum, repay in fixed monthly installments over a set term (1–10 years typical). Rates 7–25% APR depending on creditworthiness. Best for: one-off capital purchases (equipment, vehicle, fit-out) where the cash flow it generates can service the loan over its life.

2. Line of credit (revolving)

Approved for a credit limit; draw down what you need, repay and re-draw. Interest only on what you've actually drawn. Rates 8–20% APR. Best for: smoothing working capital, paying suppliers while waiting for customer payments, bridging seasonal dips.

3. SBA loan (USA only)

Government-guaranteed term loans. SBA 7(a) is the main program — up to $5M, 10-year terms common. Lower rates (6.5–9.5%) and longer terms than conventional. Slower approval (60–90 days) and heavier paperwork. Best for: established small businesses needing significant capital with time to wait.

4. Invoice finance / factoring

Sell your unpaid invoices to a factor; receive 70–90% of face value immediately, balance (minus fee) when customer pays. Fees typically 1–3% per invoice plus a service charge. Best for: businesses with long customer payment terms (60–90 days) and immediate cash needs. Caveat: customers see they're paying the factor, which can hurt relationships.

5. Merchant cash advance (MCA)

Lender advances cash against future card sales. Repaid as a percentage of daily card revenue. Avoid if possible — effective APRs often exceed 60–100%. Only worth considering when no other capital is available and the business genuinely will service the cost.

How interest is calculated

Standard amortisation: each monthly payment is split into principal and interest. Early payments are mostly interest; later payments are mostly principal. By half-way through the term, most of each payment is reducing the balance.

Monthly Payment = P × [r(1+r)^n] / [(1+r)^n − 1]

P = principal
r = monthly interest rate (APR / 12 / 100)
n = number of months

A worked example: $50,000 / 8% / 60 months

• Monthly payment: $1,013.82
• Total paid over 5 years: $60,829
• Total interest: $10,829 (21.7% of original loan)

Same loan over 10 years: monthly payment drops to $606.64 but total interest rises to $22,797 — more than double. The trade-off in every loan is monthly cash flow vs total cost.

APR vs interest rate

APR = Annual Percentage Rate — the true annual cost of borrowing INCLUDING fees, not just the stated interest rate. A loan with 6% interest plus $1,000 origination fee might have a 7.5% APR. Always ask for APR, not just the "rate". Comparing APRs is the only fair way to compare loans.

Personal guarantee

Most small business loans require a personal guarantee — if the business defaults, the lender comes after the owner's personal assets (savings, home equity). This is standard but non-trivial. Some SBA loans, larger commercial loans, and relationship-bank loans can be negotiated to limited or no personal guarantee.

What lenders actually look at

1. Debt service coverage ratio (DSCR). Your annual EBITDA ÷ annual loan payments. Most lenders want ≥1.25× — meaning EBITDA covers loan payments with 25% buffer.
2. Personal credit score (FICO >680 typical minimum, >720 for best rates in USA).
3. Time in business (2+ years for most lenders; SBA accepts 1+ year).
4. Annual revenue (typically $100k+ minimum).
5. Collateral (equipment, real estate, inventory) for larger loans.

Region-specific rate guides

• USA: SBA 7(a) 6.5–9.5%, conventional 8–25%.
• UK: high-street SME loans 7–15%, alternative lenders 12–30%.
• South Africa: prime rate ~11.75% + 2–5% margin (so 13.75–16.75% typical for SMEs).

Should you borrow?

The right question isn't "can we afford the payments?" — it's "will the borrowed money generate enough return to justify its full cost over the loan life?". Use the Business Loan Calculator to see monthly payment + total interest, then the ROI Calculator or Payback Period Calculator to assess whether the use of funds clears the hurdle.

Bottom line

• Match loan type to purpose — term for capex, line of credit for working capital.
• Compare APRs, not headline rates.
• Avoid merchant cash advances if any alternative is available.
• Borrow only when the use of funds clearly returns more than the loan's full cost.