Bank lending policies toward small businesses tend to err on the side of conservatism, and you'll have to convince the lender you're worth the risk. Learn the ins and outs of obtaining loans from large commercial banks, small community banks, credit unions and finance companies.
While banks have long served as an invaluable financial resource for American small businesses, they aren't exactly lining up to freely give entrepreneurs their money.
Banks are highly regulated in order to minimize the government's risks from insuring the accounts of depositors. And since the 2007-2009 financial crisis, regulations aren't exactly lax.
As a consequence, bank lending policies toward small businesses tend to be very conservative. That certainly doesn't mean banks aren't worth exploring—but rather that concentrating on the type of bank that best matches your needs is the best use of your time.
Banks can be roughly divided into these categories:
- Large commercial banks, which typically finance businesses with the best credit
- Small community banks and credit unions, historically the best lenders to the average small business owner
- Finance companies, which aren't any form of bank or financial institution, but can provide loans fast to business owners with poor credit
Large Commercial Banks
Many large banks target small businesses because that segment of the financial market is increasing and lenders are becoming more competitive for every business dollar.
For startup businesses, large commercial banks historically have not been an attractive source of financing. However, a large bank can be a good source for a loan if your business has been operating successfully for a couple of years.
Today, many of the larger banks claim to target small businesses because that segment of the financial market is increasing and lenders are becoming more competitive for every business dollar. More regional and national banks have increased their community profiles by creating small business departments that actively solicit local business, participate in small business seminars and sponsor local business events.
Navigating a Large Bank's Loan Review Process
What's more, these larger banks are at the forefront of developing technology that will allow them to reduce the time and cost of their loan application processing.
While a large bank's "software review" of your loan application may lack the personal involvement you're accustomed to, the availability of this option at least broadens the supply of money. In the near future, it may make all lenders more competitive in their loan rates and terms.
Of course, these large lending institutions will still require significant documentation and often more than 100 percent collateral to support a loan. Moreover, automated "cookbook" recipes for reviewing business loan applications will not favor those small business with unique profiles or with perceived deficiencies in loan application criteria.
In short, aside from secured loans and mortgage financing, larger banks are still not a major participant in small business finance. While we certainly don't discourage you from giving a big bank a shot at financing your business, the local community lender has remained a leading small business lender for good reason.
Community Banks, SBA Lender's Directory and Credit Unions
Both historically speaking and considering recent events, small community banks often offer your best option for conventional small business finance.
In fact, some commentators have predicted that in the current era of mega-mergers in the banking industry, a profitable cottage industry for community banks will emerge. And those predictions are fast becoming reality.
Between September 29, 2011 (when Bank of America announced its short-lived and never-implemented $5 debit card free) and November 5, 2011 (the grassroots-led Bank Transfer Day), the New York Times and Christian Science Monitor reported over 650,000 American moved their accounts from larger banks to credit unions and community banks.
With more consumers infusing more money into these local lending institutions, the odds of community banks and credit unions continuing their support of small businesses are great.
Obtaining a Loan Through a Community Bank
These institutions tend to be less formulaic in assessing loan applications and are more willing to consider individual factors in their decision-making.
You should consider establishing an ongoing working relationship with a specific bank even before setting up shop, or as soon as possible thereafter, to help with your loan application.
Establishing a small line of credit with a bank, even if your business does not immediately need funds, is often a good way of getting to know your banker. The more knowledgeable and familiar the lender is with the borrower, the more likely the lender is to understand and accommodate the individual needs of the small business. And if you apply for a line of credit and then don't need to use it, you'll build up a very favorable impression of your business.
Advice on credit issues, as well as general business expertise, have always been offered as a service by some banks. But with the increased competition among banks, many more institutions are promoting and packaging their loan offerings with these additional "smart money" services.
Most small businesses can benefit from the experience of an experienced banker or lender, and your choice of a lending institution and a specific person within the institution should take this potential benefit into consideration.
Finding Community Banker Lenders
The Small Business Administration publishes a state-by-state directory of small business lending reported by commercial banks.
Although this directory of Certified and Preferred Lenders should not be your exclusive source for selecting the bank that's best for you, the compilation can help identify banks in your area that are lending large amounts to small businesses and that have experience with small business needs.
The information on small business friendly banks in your area can be found at the SBA's Local Resources map.
Financing with Credit Unions
Credit unions are all the rage among consumers, and they are gaining even more lust among small business owners seeking financing.
Theses financial institutions are much like community banks except they're owned by:
- Employees of a company
- Other groups
Credit unions exist primarily to provide benefits to the members, and they have different regulatory requirements that may permit them to offer interest rates and other terms that may be more favorable than those offered by a bank.
The amount you will be able to borrow from a credit union may not be large, but this source of funds may be helpful in making initial purchases for your business.
Consumer and Commercial Finance Companies
If you're dead set on—or are strictly limited to—obtaining financing through a lending institution and haven't had any luck with large banks, community banks or credit unions, you have a few last-ditch options.
Consumer finance companies make small, secured, personal loans that are often limited to several thousand dollars.
These companies typically impose higher interest rates and processing fees than banks or credit unions. On the other hand, consumer finance companies tend to be less conservative in making loans and may extend a high-interest loan to applicants who have relatively poor credit histories.
The higher cost of the loans is thereby tied to the higher risk assumed by the consumer finance company.
Because of the high interest rates they charge, consumer finance companies are not the usual lender of choice for small businesses and entrepreneurs.
Financing Through Commercial Finance Companies
The only noteworthy difference between consumer financing and commercial financing is the former offers personal loans and the latter offers business loans.
As a small business owner, you would primarily use a commercial finance company to borrow money for the purchase of inventory and equipment. These financiers can be a useful resource, particularly if your business has adequate collateral available to support a loan.
Commercial finance companies usually do a great deal of accounts receivable and inventory financing. Small businesses involved in manufacturing or wholesaling may be most interested because they tend to need to be highly collateralized.
Because commercial finance companies typically offer only loans secured by commercial assets, these institutions are used primarily by established businesses, and they can't offer much for startups. As with consumer finance companies, the higher cost of borrowing from a commercial finance company may make this type of lender appealing only after a loan application has been denied by a bank.
Key Advantages of Commercial Finance Companies
When you decide to borrow from a commercial finance company, you'll likely benefit from:
- Less conservative rules than a traditional bank offering small business loans and a willingness to make riskier loans (commercial finance companies are subject to less regulation and can assume more risk)
- Flexible lending terms
- Short-term loans (less than one year) as well as longer-term loans
- A good source to investigate for asset-backed loans, especially if you cannot obtain additional debt from a traditional bank because your business is already highly leveraged
Disadvantage of Commercial Finance Companies
Like every loan, you have to weigh the pros against the cons:
- Commercial loans are typically highly collateralized loans. These lenders closely scrutinize your assets for value and liquidity. You'll normally be asked to include equipment, inventory or accounts receivable for collateral
- Riskier loans likely mean higher interest rates than banks charge. Commercial finance companies may also have significant prepayment penalties to deter a borrower from refinancing with a conventional bank if the borrower improves his or her creditworthiness
- While flexible loan terms can be attractive, they also require careful review of the terms of the loan, including interest computation and payment method, prepayment rights, and default terms