Be Mindful of Business Debt: Here’s How to Stay on Top of Your Finances
by Scott K. Schmidt, Chief Financial Officer at U.S. Money Reserve
Debt is a tricky topic for both individuals and small businesses. It can make or break your financial future, and it can have tremendous long-term effects both personally and professionally.
According to Value Penguin, a site owned by LendingTree, the average small business loan in 2018 (the most recent data available) totaled $663,000. Depending on the type of loan and the lender, however, that number was as high as $1.2 million.
Small businesses use this debt to finance growth, purchase equipment or real estate, hire employees, and manage inventory and marketing. Small businesses also use debt to sustain growth during lean and uncertain economic times. Debt can act as the fuel that keeps your business on track, but taking on the right kind of debt at the right time requires balance and a smart approach. So how do you stay on top of your finances as a small business owner and remain mindful of your debt? Read on to find out.
Get Familiar with the Different Types of Business Debt
Just like you can take on personal debt, your business can take on many different types of business debt. Some are riskier than others, so it’s essential to understand the differences before choosing the right kind of debt for your business.
Debt financing for small businesses, just like debt financing for individuals, generally involves borrowing money from a lender and having to pay that lender back with interest on a set timetable. In general, certain types of debt can be used for certain types of activities. Some kinds of debt are ideal for startups, while other types of debt are better for well-established companies.
It’s important to know that both your personal credit score and your business credit score can be used to determine your creditworthiness. You need to maintain a good balance of debt and income to keep both your scores high. Maintaining an excellent personal and business credit score will help get you access to credit when you need it in the future.
It’s also essential to understand the types of loans available to small business owners and choose the right kind of loan for your needs. There are three main categories of business loans. They include:
Installment loans: These kinds of loans are distributed to borrowers in one lump sum and repaid at regular, predetermined intervals. Fees are determined by the interest rate or the factor rate that you get. This kind of loan is the most similar to a mortgage you would use to purchase a home. Most businesses can apply and get approved for these kinds of loans.
Business line of credit or revolving credit: This type of debt allows you to access the credit in your business on an as-needed basis. This is most similar to a home equity line of credit (HELOC) or a credit card you might use in your personal life. If and when you draw on this credit, you must pay it back within a set period of time to avoid penalty fees and potential negative marks on your credit score. Most small businesses that have equity can get a business line of credit.
Loans on future revenues or unpaid invoices: These loans can include things like factoring, trade credits, merchant cash advances, or invoice financing. This type of financing tends to be a bit more risky than borrowing from a traditional lender and can end up being very costly.
In general, there are more types of installment loans than other kinds of loans. They include the following:
SBA loans: The Small Business Administration (SBA) and its partners offer these kinds of loans. If you want an SBA loan, you must have great business and personal credit scores and meet the requirements for the type of loan that you are applying for. You get these kinds of loans from SBA banking partners. The SBA is not a lender itself. The benefit of these kinds of loans is that they are generally more affordable than other types. These kinds of loans can be used for a variety of things that include everything from working capital and equipment purchases to real estate purchases and refinancing. You can also use these kinds of loans to purchase an existing business.
Short-term loans: These kinds of loans are generally used by B2C companies that need quick cash. A short-term loan is a form of installment loan and is distributed in one lump sum. It is then paid back in regular installments as determined by the agreement. Borrowing fees are determined by a factor rate.
Equipment loans: These can be SBA loans or short-term loans. These loans have to be used to purchase equipment.
Microloans and peer-to-peer loans: These are generally installment loans. Microloans are loans for less than $50,000. These loans are generally used by startups or small businesses that only need a small amount of capital. Peer-to-peer loans are usually smaller loans facilitated through various online vendors. They can carry a wide array of terms and payment timelines.
Personal loans: You apply for these loans as an individual (rather than as a business), and they can be used in any way you want. Generally, personal loans carry very high interest rates.
There are fewer types of revolving credit loans. These types of loans can be secured or unsecured. These kinds of loans are similar to credit cards or lines of credit where the rates and payment terms are somewhat fluid.
Business credit cards and revolving lines of credit: These behave the same way personal credit cards do. When you use the credit line, you have to pay it back with interest. The line remains open until you close it. Every small business can apply for a business credit card/line of credit. A revolving lines of credit is similar to a HELOC or home equity line of credit you might use to make improvements to your home. Businesses must have good credit and positive equity to qualify for a revolving line of credit.
There are also more risky loans on future revenues and outstanding invoices that can be used to finance your business. This kind of lending is usually for smaller amounts and shorter periods. It’s best to do your research before signing up for these kinds of loans so that you know what you are getting into.
Good Business Debt Versus Bad Business Debt
Once you have a good understanding of the types of debt out there, how do you determine the difference between good business debt and bad business debt?
Like personal debt, loans that are riskier and tend to be more predatory are considered to be bad small business debts. Loans that have better rates and repayment terms are generally considered to be good debts.
The best rule for understanding the difference between good and bad debt is to look at what that debt is going to be used for. Good debt should act as an investment in your business. It should help bolster your growth and be a debt that you can realistically pay back within the required timeline. Debts that can help you grow your business’s income are generally considered to be good debts.
Borrowing money for things that won’t help you grow or sustain your business is generally best avoided.
When Should you Take on Debt as a Small Business Owner?
The best way to decide when to take on debt is to assess both what you are going to use the money for and when you plan to use it. You should also consider the type of loan you are looking to get when deciding on when you should take on debt as a small business owner.
Timing is critical when it comes to managing your small business. If you take a loan too early and aren’t ready to use it, you could end up spending more time making payments on the loan. If you take the loan out too late, you could struggle to fill the gap.
All that is to say, you should carefully check your options and consider your timing when you are looking to take on debt as a small business owner.
The Bottom Line on Managing Your Small Business Debt
The best way to remain mindful of your small business debt is to know your options, understand your business, and carefully consider your timing. It’s essential to have a good grasp of all these aspects of managing your small business finances because taking on debt can truly make or break your small business. Done right, debt can provide a tremendous boon to your bottom line and your long-term success. Done wrong, taking on debt can literally drive your business into the ground. Just like managing your personal debt, it’s crucial to manage your business debt carefully to ensure that you are taking on the right balance to guarantee that your company survives well into the future.
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