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Microloans for Startups Explained

11/21/20 | 6 MIN READ

A microloan would be most advantageous to smaller businesses.

If you have recently developed a startup but are struggling to obtain funds that would allow you to grow, one option that you might want to consider is a microloan, which gives you a relatively small and short-term loan that can help you hire some employees, pay for some equipment, or get your startup off the ground. You should consider microloans if you have had difficulty obtaining a loan from a traditional bank.

Since these loans are usually around $50,000 or less, the risk of taking out one of these loans is minimal. Another way that this type of loan differs from a traditional loan is that microloans typically come with higher interest rates and are designed specifically to be used by small businesses.

The following article goes into detail about what microloans are and why startups should consider using them.

What is Microlending?

woman in teal t-shirt sitting beside woman in suit jacket

Microlending  refers to the act of providing individuals and small businesses with microloans. This type of lending is unique in that the lenders are typically individuals or online lending firms as opposed to banks or other large financial institutions.

While microlending typically isn't available from large financial institutions, it's considered to be somewhat appealing to individual lenders because microloans will usually come with higher interest rates. For individuals who provide microloans, higher interest rates make it possible for the lender to obtain high returns on their investment.

Is Microloan Ideal?

white ceramic piggy bank

When you are creating a startup, a microloan could be the ideal way for your business to get the funds it needs to start growing and getting your ideas off the ground. A microloan would be most advantageous to smaller businesses that have less employees and minimal capital needs when compared to larger companies.

If your startup is still in its initial phases, you'll likely be at a size where one of these loans would be highly beneficial towards helping you grow. If you're confident that your business idea is a sound one, there isn't much risk of obtaining a microloan as long as you know you can make the monthly payments.

This type of loan is also ideal if your business has been unable to receive a loan from a traditional bank. Many traditional banks will be wary of providing larger loans to young startups that don't have a solid history of success. Most banks will only provide traditional loans to companies that bring in large revenues, have been in business for many years, and have extensive documentation, which you likely wouldn't be able to qualify for if you've just started a business.

Requirements for these loans aren't strict, which is why you should look at this option if your credit score isn't high enough for a traditional loan. Since this is a short-term loan, paying it off in a few years will help you raise your credit score, which could give you the option of obtaining a traditional loan in the future.

Sources of Microloans

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While it's possible for microloans to be provided by individual lenders, they can also come from online lending institutions  and governments. In most cases, traditional banks and similar financial institutions won't offer this type of loan because of the higher risk that comes with it. However, it's relatively easy to find a microloan that has decent interest rates and will provide you with the money you need to start growing your business.

Online Lending Institutions

In recent years, online lending institutions have become increasingly popular as a source of lending microloans to smaller businesses that might not have the credit requirements that are needed to obtain a traditional loan. The lenders don't exactly classify themselves as microlenders. However, they still offer smaller loans that startups can gain access to, which is why you should at least consider applying for a loan at one of these institutions.

While there are many online lending institutions that you can borrow from, a few of the more popular lenders include OnDeck, LoanBuilder, and Credibly.

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  • When you apply for a microloan at OnDeck, the max borrowing amount is set to $500,000 with potential interest rates ranging from 9.4-99.7 APR. A credit score of 600 is necessary to apply for one of these loans.

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  • As for LoanBuilder, they offer microloans for as much as $500,000 with a factor rate of 2.9-18.72 percent. A credit score of 550 is needed if you want to apply for a LoanBuilder microloan.

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  • The max borrowing amount with Credibly is $400,000. Their factor rates start at nine percent with a required credit score of 500. While the interest rates from these lenders may be high, their approval process is quick and straightforward.
    • However, because of these high interest rates, it's important that you first calculate what you would owe over the period of the loan if you want to be certain that obtaining this loan is a wise business decision.

Government

government building

The government also offers microloans through what's known as the SBA. The Small Business Administration is a government agency that was first created in 1953 to provide small businesses and entrepreneurs with support that they require to grow and cultivate their ideas. Loans that are obtained through the Small Business Administration are considered to be highly beneficial because they typically come with great terms and low rates.

The microloan program  that's available through the SBA has some great terms when compared to some of the loans available with an online lender. For instance, the interest rates with this program range from 6-13 percent. The term lengths can last for up to six years. The one downside of obtaining this type of microloan when compared to the ones available with online lenders is that there's a limit to how much money you can apply for. The available borrowing amount is set to $500-$50,000. Even though $50,000 is available, the average loan amount that these programs provide is $13,000.

When you obtain one of these loans, you can use the funds for inventory, supplies, equipment, machinery, and fixtures. You can also use the funds as working capital for your day-to-day operations. You cannot, however, use one of these loans to refinance your current business debt or to purchase real estate for your company. Keep in mind that there are times when you will be required to provide some collateral along with a personal guarantee. This guarantee must be given by an individual who owns 20 percent of the company or more.

Pros and Cons of Microloans

person writing on paper on desk

As with every type of loan, there are a variety of pros and cons associated with microloans. Before you apply for one of these loans, it's recommended that you brush up on the positives and negatives. Doing so should help you avoid making a bad business decision.

Pros of Microloans

  • Access to capital that you otherwise would be unable to qualify for
  • These loans come with fixed interest rates, which means that repayment of the loan should be easier and more straightforward
  • Paying off one of these loans can help you improve your credit, which will be useful if you were unable to obtain a traditional loan because of bad credit
  • Many lenders that offer microloans also provide free training to entrepreneurs that can help them improve their startup and better manage their funds

Cons of Microloans

  • Unless you obtain this type of loan from an online lending institution, the loan amounts are typically small and can be well below $50,000
  • Many microlenders charge very high interest rates, which can cause monthly payments to be much higher than you had anticipated

Requirements for Microloans

sticky notes on paper document beside pens and box

Before you obtain a microloan, there are several things that you should do to make sure that you are ready to apply for one of these loans.

Some of the basic requirements for microloans include:

  • Make sure that your business plan is in order and that you know what the funds will be used for
  • Conduct a credit check before taking steps to increase your credit score
  • Be prepared to invest yourself since some microlenders will require collateral and even a down payment, the latter of which is only applicable with SBA loans

Getting Started with Microloans

person holding U.S. dollar banknote

Getting started with microloans is very simple as long as you know how to find the right lender. If you don't have a great credit score but need some basic funding for your startup, it might be a good idea to apply for a microloan. The same is true if your lack of business history is causing traditional banks and lending institutions to turn down your application. Since these loans typically provide applicants with less than $50,000, the risk of obtaining a loan is kept in check. However, it's recommended that you avoid microloans that come with very high interest rates unless you are certain you will be able to make the monthly payments on time.

Credit Score Qualifications

The qualifications that are needed to obtain a microloan are much less restrictive than traditional loans. First, you should find out what the credit score requirements are with the lenders that you're considering. If you want to apply for an SBA loan, you will need to have a credit score between 620-640 at the lowest. If your credit score is lower than this, you might want to look at online lending institutions like the ones mentioned previously. Depending on the online lender you apply with, it's possible for your application to be approved even with a credit score of 500.

What's Next?

Once you've made sure that you meet all of the necessary requirements, it's recommended that you shop around for the lowest interest rate, which will allow you to pay much less in the long run. The application process for one of these loans is very simple. However, you will need to provide such documentation as business and personal financial statements, financial projections, and bank statements.

If you apply with an online lender, you should receive a response within a few days. For an SBA loan, the response may take as long as two weeks or so.

Other Funding Possibilities

woman sitting on yellow armless chair near gray laptop computer

When you're searching for ways to fund your startup, there are going to be pros and cons with every funding option available to you, which is why it's important that you determine what your needs are. If your main goal at the moment is to get your business off the ground, a small microloan may be the right funding option for you. However, there are several additional funding possibilities that startups have access to, which include everything from angel investors to venture capital firms.

The funding option that's right for you largely depends on what funding round you are in. If you are in the early stages of your startup and require some seed funding, you might want to seek funding from angel investors. On the other hand, funding from venture capital firms is ideal if you're ready to grow your company substantially.

If you have additional questions or would like some more info on the many possibilities available to you, contact University Lab Partners today.

 

Revised 11/16/2020

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