Credit Sources and Products Used by Small Businesses

Every year, millions of American small businesses seek outside financing for various reasons. Many small businesses use more than one credit product at a time and apply to multiple sources.

How Small Businesses Finance Themselves

Prior to COVID-19, the principal means by which small employer firms financed themselves was retained business earnings. From 2016 to 2019, between two-thirds and three-quarters of respondents in the Small Business Credit Survey (SBCS) cited this as their primary funding source.¹

Figure 1. Source: Federal Reserve Banks, Small Business Credit Survey: 2022 Report on Employer Firms. 

Most small businesses use external financing products (loans, lines of credit) on a regular basis, but less than half apply for new external financing in any given year. Before the pandemic, the top reasons for seeking external financing were, “expand business, pursue new opportunities, or acquire business assets,” and “meet operating expenses (for example, wages, rent, and inventory costs).”²

When Small Businesses Seek External Financing

Small businesses utilize different forms and sources of credit. According to the SBCS, less than 10% of small employer businesses seek equity investment each year. This is consistent with data from other sources. Among those small businesses seeking new credit each year, loans and lines of credit are the most frequently sought products, followed by credit cards.³ Small businesses are resourceful, using multiple types of loans and lines of credit on offer to them. Standard business loans and lines of credit are the most frequently used, but non-trivial shares of small businesses also seek credit each year through auto/equipment loans, cash advances, and SBA-backed products.

 

Figure 2. Source: Federal Reserve Banks, Small Business Credit Survey, various years. Note: data for auto/equipment loans and cash advances not available for 2014. Data for 2020 and 2021 exclude emergency funding applications for PPP and EIDL. 

Both large and small banks continue to be the primary destination for small employer firms when seeking credit—yet approval rates (for full or partial amounts) vary widely among lenders. The highest credit application approval rates among small businesses are found at community development financial institutions (CDFIs)—these mission lenders serve a smaller set of businesses, though, and application rates are low.⁴ Credit unions also have low application rates for credit from small businesses but compared to CDFIs, lower approval rates.⁵

Small businesses apply for credit at the highest rates with banks, both large and small. Approval rates at banks, on average, vary from year to year and small banks tend to have higher approval rates than large banks. Credit application rates are lower at online lenders and finance companies, though approval rates at these lenders can sometimes be higher. In 2021, approval rates were lower across the board than in 2019, before the pandemic. At small banks, for example, approval rates dropped from 74% to 66%, and from 80% to 51% at online lenders.

Credit applications and approvals come with tradeoffs at different types of lenders. According to the annual SBCS, finance companies and online lenders receive the lowest satisfaction scores from small businesses. Small businesses prioritize “speed of decision” in their calculus of when to apply at nonbank lenders but cite high interest rates and unfavorable payment terms as reasons for dissatisfaction. Many small businesses already use banks for basic financial services and prioritize that existing relationship when opting to apply for new credit. Yet small businesses express dissatisfaction with the “long wait for credit decision” and “difficult application process” at banks.

These considerations and tradeoffs shape credit decisions made by small businesses and, consequently, the overall landscape of small business financing. More detail will be explored in future pieces.