How business loans work: a plain-English guide for UK businesses

Most businesses borrow at some point: to buy stock, take on a bigger contract, hire or move premises. Borrowing isn't a sign of trouble. Borrowing the wrong way, for the wrong length of time, often is.

This guide covers the essentials, from the main kinds of finance to what happens between applying and the money arriving.

The moving parts of any loan

Every business loan has the same basic pieces. Learn these and the rest is detail.

• Principal. The amount you borrow.
• Interest. What the lender charges for the use of its money, usually shown as a rate per year.
• Term. How long you have to repay, from a few months to many years.
• Instalments. The regular payments, usually monthly, that repay the principal and the interest together.
• Fees. Charges on top of interest, such as an arrangement fee when the loan starts.
• Security. Anything the lender can claim if you don't repay, such as property or equipment. A loan with security is secured. One without is unsecured.
• Personal guarantee. A promise from a director or owner to repay the loan personally if the business can't.

The rate can be fixed, so your instalments stay the same for the whole term, or variable, so they move with a benchmark such as the Bank of England base rate.

The main types of business finance

"Business loan" is often used loosely for any borrowing. In practice there are several distinct products, and matching the product to what you're paying for matters more than anything else.

Term loans

A term loan is the classic business loan. You receive a lump sum and repay it in fixed instalments over a set term. It suits one-off costs with a clear price: a refit, an expansion, buying out a partner, a large order.

Secured and unsecured loans

An unsecured loan isn't tied to a specific asset. It's usually quicker to arrange, but amounts tend to be smaller, terms shorter and rates higher, and directors are usually asked for a personal guarantee. A secured loan is backed by an asset, most often property. It can mean bigger sums, longer terms and lower rates, but you could lose the asset if you can't repay, and the legal work takes longer. Our guide to secured vs unsecured business loans goes into the trade-offs.

Overdrafts and revolving credit

These are flexible facilities rather than lump sums. You have a limit, draw what you need, repay when you can and draw again, paying interest only on what you're using. They suit uneven, recurring needs such as paying suppliers before customers pay you. An overdraft can usually be reduced or withdrawn by the bank at short notice, which is why it shouldn't fund long-term spending. See overdraft, revolving credit or a loan.

Asset finance

Asset finance pays for equipment and vehicles, with the asset itself as the lender's main security. Hire purchase leads to you owning the asset. Leasing lets you use it without owning it. Because the asset secures the deal, it's often easier to arrange than an unsecured loan of the same size. Our guide to hire purchase vs leasing explains the differences.

Invoice finance

If you sell to other businesses on credit, invoice finance releases most of the value of your unpaid invoices within days, rather than making you wait 30, 60 or 90 days for customers to pay. It grows as your sales grow. See invoice finance vs a business loan.

A useful rule: match the length of the finance to the life of what you're buying. Paying this month's wages with a five-year loan, or a building with an overdraft, is how businesses get into trouble.

How lenders decide

Each lender has its own rules, but almost all of them are trying to answer the same few questions.

• Can the business afford the repayments? This is the big one. Lenders look at your business bank statements, usually the last three to six months, to see money coming in, money going out and what's left. For larger loans they'll also want your accounts and sometimes management figures or forecasts.
• Do you pay what you owe? Lenders check the business's credit file and, for smaller companies, the directors' personal credit files too. Missed payments, county court judgments (CCJs) and frequent returned payments all count against you.
• How long have you been trading? Many lenders want to see at least one or two years of trading history. Some will consider younger businesses, usually for smaller amounts or with more security.
• What's the money for? A clear purpose that should help the business earn or save money is easier to lend against than a vague one.
• What happens if things go wrong? Security, a personal guarantee or both reduce the lender's risk, and can improve the terms you're offered.
• What else do you owe? Existing loans, finance agreements and tax arrears all reduce what a lender thinks you can afford.

Sector matters too. Some lenders avoid particular industries and others specialise in them, which is one reason a business turned down by one lender can be approved by another.

How much you can borrow, and for how long

There's no standard answer, and anyone who quotes one without seeing your figures is guessing. As a broad guide:

• Unsecured loans commonly range from a few thousand pounds to several hundred thousand for established businesses. Many lenders size them against your turnover and the spare cash your bank statements show each month. Terms are often between one and five years.
• Secured loans can be much larger, depending on the value of the security, and can run for longer. Loans secured on commercial property can last well beyond ten years.
• Short-term loans for specific gaps, such as a tax bill, often last 3 to 12 months.

Your interest rate depends on the lender's view of your risk, the term, the security and wider interest rates. Rather than fixating on a headline rate, compare offers on the total amount you'll repay.

How repayment works

Most term loans are amortising. That means each monthly payment is the same, but what it's made of changes over time. Interest is charged on the balance you still owe, so in the early months a larger share of each payment goes on interest. As the balance falls, less goes on interest and more pays down the loan itself.

An illustration, not a quote. Say you borrow £12,000 over 12 months at an interest rate of 1% a month (12% a year), with no fees. Your monthly payment is about £1,066.

In month one, you owe £12,000, so the interest is £120 and the other £946 or so reduces the balance. By month twelve you owe only about £1,056, so the interest is about £11 and nearly all of the payment clears the loan.

Over the year you repay about £12,794: the £12,000 you borrowed plus about £794 in interest.

Two things follow from this. First, repaying early saves the most interest early in the term, which is when an early repayment charge may also be highest, so read the terms. Second, not every lender works this way. Some quote a flat rate, charging interest on the original amount for the whole term even though you're paying it down, which costs more than the same number quoted as a reducing-balance rate.

Some loans have a different shape: an initial interest-only period, where you pay just the interest before repayments of the principal start, or a balloon, a larger final payment that keeps monthly instalments lower. Both cost more interest overall, because you owe more for longer.

From application to funding

Most lenders follow the same broad steps. What changes is how long each one takes.

A few points matter at each stage:

• The eligibility check usually involves only a soft credit search, which doesn't affect your credit score.
• Documents are where most delays happen. Have recent business bank statements, the directors' ID and, for larger amounts, your latest accounts ready before you start.
• Underwriting normally includes a hard credit search, which other lenders can see.
• The offer should set out the amount, rate, fees, term, total repayable and any conditions, such as a personal guarantee. Read it all before you sign.

For a straightforward unsecured loan with clean paperwork, the whole process can take a few days. Secured loans usually take weeks, because of the valuation and legal work.

Who is protected, and how

Most lending to limited companies and LLPs is unregulated. You have your contract and the general law, but fewer protections than with personal borrowing. Lending of £25,000 or less to sole traders and small partnerships is regulated by the Financial Conduct Authority (FCA), which brings extra rules on how the lender treats you.

Government-backed schemes, run through the British Business Bank, sometimes sit behind business loans. Under these, the government guarantees part of the loan to the lender, not to you: you remain liable for the full amount. Schemes and their rules change, so use GOV.UK's finance and support for your business finder to see what's currently available.

Common mistakes to avoid

• Choosing the wrong product. A loan for a recurring cash flow gap, or an overdraft for a long-term purchase, causes problems later even if the price looks good.
• Comparing rates instead of totals. A lower rate with a large fee can cost more than a higher rate without one.
• Borrowing more, or for longer, than you need. Interest is charged on every pound for every month you hold it.
• Applying everywhere at once. Several hard searches in a short time can look like desperation to the next lender.
• Signing a personal guarantee without reading it. It can put your own home and savings on the line. Understand exactly what you're agreeing to first.
• Not asking about early repayment. If you expect to clear the loan early, check what that would cost before you sign.

Questions people ask

How do business loans work in the UK?

A lender pays your business a lump sum, and you repay it with interest in regular instalments, usually monthly, over an agreed term. The lender decides based on your affordability, credit history, time trading and any security. Lending to limited companies is generally unregulated, while loans of £25,000 or less to sole traders and small partnerships are regulated by the FCA.

What do lenders look at for a business loan?

Mainly your business bank statements, to see whether you can afford the repayments. They also check business and personal credit files, how long you've been trading, what the money is for and what you already owe. For larger loans, they'll want your accounts as well.

How long does it take to get a business loan?

A straightforward unsecured loan can often be arranged in a few days if your documents are ready. Secured loans usually take several weeks, because the lender needs a valuation and solicitors need to complete the legal work.

Do I need security for a business loan?

Not always. Many business loans are unsecured, though directors of limited companies are usually asked for a personal guarantee. Larger loans, longer terms and lower rates are more likely to need security such as property.

Can I repay a business loan early?

Usually, yes, but some loans carry an early repayment charge. Check the agreement before you sign. If your loan is regulated by the FCA, you have a legal right to repay early.