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As a small business, you might need to borrow funds to help you start up, expand, buy premises, or invest in inventory or machinery. 

But with a wide range of business loans to choose from, it’s not always easy to know where to start. This guide explains how the different types of business loans work so you can make the right decision for your business.

12 types of business loans explained 

We’ve outlined some of the most common types of business loans below:

1. Unsecured business loans

An unsecured business loan doesn’t require you to use an asset as collateral, making it less risky for you but riskier for the lender. As a result, the interest rates tend to be higher. 

The amount you can borrow with an unsecured business loan depends on your credit history and your business’s financial situation, with stronger businesses able to borrow more. 

You repay the borrowed amount, plus interest, in fixed monthly instalments over a set term. This is usually between one and five years, although some lenders might offer terms of up to 10 years.

Note that some lenders might also require you to sign a personal guarantee before offering you an unsecured loan. This means you become personally liable for repaying the debt if your business is unable to do so. 

2. Secured business loans

A secured business loan requires you to use an asset, such as property, as security.  

This reduces the lender’s risk, meaning you can usually borrow more. Depending on the value of your asset, a lender might let you borrow up to £15 million. The collateral also means you might find it easier to qualify for a secured loan if you have a poor credit rating. 

However, if you default, the lender can repossess your asset to recoup its money. So, it’s essential to ensure you can afford the repayments before taking out the loan. Again, you make your loan repayments each month over an agreed period of time – often up to 25 years. 

3. Short-term business loans

As the name suggests, these loans must be repaid over a short period, which can be useful if you need funds quickly for emergency expenses. However, repayments are usually higher, as the loan term is often only a few months, so it’s prudent to check you can afford this type of borrowing before you apply.

4. Working capital loans

A working capital loan is short-term funding used to cover temporary cash flow shortages. Rather than investing in growth, this type of loan focuses on sustaining your business’s daily operations and is often easier to apply for.

5. Startup business loans

If your business is less than three years old, you could apply for a startup loan. These provide a lump sum for cash flow, staff wages, rent or equipment. 

The government-backed scheme offers £500 to £25,000, along with free mentoring and business plan support. You must be at least 18, live in the UK and have (or plan to start) a business that has been trading for less than 36 months.

6. Government loans

In addition to the Start Up Loan, the partially government-back Growth Guarantee Scheme supports access to finance for small UK businesses looking to invest and grow. 

Replacing the Recovery Loan Scheme, it allows eligible businesses to borrow between £25,001 and £2 million, with repayment terms, from three months to six years. As well as term loans, you can access asset finance, invoice finance and asset-based lending. 

7. Invoice financing

Invoice financing is a type of secured business finance whereby you borrow against the value of your unpaid invoices. Rather than waiting for customers to pay their invoices, a lender advances you a large percentage of the invoice value upfront – typically between 70% and 95%. 

Invoice financing can work slightly differently, depending on whether you use invoice factoring or invoice discounting.

With invoice factoring, the lender collects the payment for your invoices directly from your customers and then pays you the remaining balance, minus any fees or charges. 

With invoice discounting, you collect the payments for your invoices as usual and then repay your loan as agreed. This means your customers won’t be aware you’re using an invoice discounting provider, and the cost is usually lower. 

8. Asset financing

You could consider asset financing if you need to access business equipment, machinery and vehicles, but can’t afford to pay for these items outright. There are two main types of asset finance – hire purchase and lease financing. 

With hire purchase, the lender retains ownership of the asset until you make the last payment. Your regular payments cover the cost of buying the item, plus interest. At the end of the agreement, you own the item outright.

With lease financing, the lender buys the item you need, and you rent it back from them for a fixed monthly payment. At the end of the term, you might have the option of returning the item, buying it for an agreed fee or continuing to rent it.

9. VAT loans

VAT loans are a type of short-term loan designed to help you cover the cost of your VAT bill. When you apply for a VAT loan, usually with a specialist lender, the lender pays the amount borrowed directly to HMRC to pay off your VAT bill.

You then repay the loan to the lender in fixed monthly instalments over a term of three, six, nine or 12 months. These loans are usually secured, meaning you need to use an asset as security. Some might also ask for a personal guarantee. 

10. Merchant cash advance

A merchant cash advance is another way to borrow a lump sum of cash, but it’s only suitable if your business accepts debit and credit card payments. A lender gives you an upfront sum of money, based on how much money your business makes from card sales each month, and you repay this using a percentage of your card transaction sales, plus fees. 

Repayments fluctuate in line with your income, so if your business is doing well, you pay more, but when business is quieter, you pay less. 

11. Peer-to-peer loans

With peer-to-peer lending, you borrow money from other individuals or businesses through a peer-to-peer lending platform. Peer-to-peer loans tend to come with lower interest rates, offering a cheaper alternative to traditional loans. You might also find it easier to qualify for a peer-to-peer loan if you have poor credit.

However, it’s important to check the fees and bear in mind that if you default on the loan, you may not benefit from the same protection as you would with a traditional lender. 

12. Credit lines

A business line of credit is a flexible way to borrow funds. Instead of applying for a fixed lump sum, you draw money as and when required, up to your agreed limit. 

You only pay interest on the amount you borrow, and repayments are usually more flexible than term loans. In many cases, once you repay what you owe, you can borrow up to your full credit limit again, which is why it’s known as a revolving line of credit. 

This can be a good option if you’re not sure how much you need to borrow. 

How to choose the right type of loan for your business

When weighing up which loan type is best for your business, it’s important to consider the following factors:

• How much do you need to borrow?

• How long do you need to borrow for?

• Do you have sufficient assets to use as security, or would you prefer to stick to unsecured borrowing?

• Do you prefer to borrow a fixed lump sum or take advantage of more flexible borrowing?

• What do you plan to use the funds for?

• Have you checked the eligibility criteria?

• Do you have a good business credit rating?

Answering these questions can help you determine which type of small business loan you are likely to qualify for and which is most suitable for your business. 

Before applying, double-check your eligibility for a business loan. Also, ensure that you can afford the loan repayments and that you have a solid repayment plan in place.