A Comprehensive Guide to Debt Financing
Small business owners are facing a tough time as a result of the Coronavirus sweeping the nation. Lenders requirements have become more strict and affordable debt financing is now more difficult to find.
Small businesses have been among those most affected by mandatory closures and other safety measures designed to slow the spread of the virus. While there are some relief programs designed to help business owners navigate this uncertain time, many will find themselves needing to borrow money.
Fortunately, there are a wide variety of debt financing options available to business owners. Keep reading to learn more about debt financing and your options as a business owner in 2020.
What is Debt Financing?
Put simply, debt financing refers to financing your business with a loan.
Your business will borrow money from a lender. You can use the money for capital expenditures or as working capital but you have to pay back the lender the amount of the loan and interest.
Debt financing includes both secured and unsecured loans. Secured loans involve putting up some type of collateral that you will forfeit if you don’t repay your loan.
Examples of collateral for a business loan include:
- Unpaid invoices
- Real Estate
There are also different term lengths available with business loans. Longer-term loans are most often used to acquire and maintain fixed assets like property or equipment. On the other hand, short term loans are designed to quickly provide businesses with working capital.
How Does Debt Financing Work?
When many business owners think of debt financing, they think of traditional loans from a bank. Modern debt financing includes many options beyond the traditional small business bank loan.
Today there are a variety of loan products designed to fit the needs of many kinds of business owners and provide them with the funding they need.
What’s important to keep in mind is that all forms of debt financing do require repayment of the money you borrow. If you don’t pay back your loan, your business, and oftentimes you personally as the business owner, will be held liable.
Examples of Debt Financing
The term debt financing refers to many different kinds of loans. As the number of small business owners in the U.S. has grown, so has the number of available lenders.
Debt financing includes all types of borrowing including bank lines of credit, personal loans, loans from family or friends, real estate loans, government-backed loans, asset-based loans, and credit cards.
Alternative financing tends to include options like business grants and venture capital funding that you don’t have to pay back.
Now, let’s take a look at some of the most common types of debt financing in greater detail.
Term loans are the simplest type of debt financing. When you think of a business bank loan, you are likely thinking of a term loan.
With this type of loan, you borrow a specific amount of money for a stated business purpose. You pay back the loan over a fixed amount of time (the term) and usually at a fixed interest rate.
This type of loan is often the first choice for business owners. This is because the monthly payments are predictable and the money can be used for a wide range of business purposes. You can easily calculate the cost of the loan when you choose a term loan with a fixed interest rate.
SBA Loans are an Affordable Type of Debt Financing
As a small business owner, you have a unique opportunity to take out loans that are backed by the U.S. government. While they don’t issue the loans themselves, the Small Business Administration (SBA) guarantees the loans for small businesses.
This means that lenders are more likely to approve these loans. The SBA exists to help business owners gain access to funding, improve their business, and find contracting opportunities. Let’s take a look at the 3 most common types of SBA loans.
If you’re a solo entrepreneur or a new small business owner, you might only qualify for a small loan. In many cases, the amount you need to borrow won’t meet lenders’ lower limits.
The SBA microloans program exists for business owners like you. If you need to borrow between $500 and $50,000, this program may be right for you.
Loans under this program are designed for business owners who haven’t previously received a traditional bank loan and don’t have a strong business credit history. While the SBA offers guidelines for loan rates and qualifications, intermediary lenders ultimately make these calls.
This is the most common type of SBA loan. 7(a) loans are a great option for a wide variety of businesses because they offer the most flexible terms and qualifications.
Business owners can borrow up to $5 million dollars under this program. These funds can be used for start-up costs, debt refinancing, working capital, equipment, and real estate purchases.
The intermediary lenders will determine who qualifies for a loan and what the cost of the loan will be. Because these loans are backed by the SBA, lenders are more likely to approve small business through this program.
If you’re the owner of an established business and you are looking to borrow a significant amount of money to make a fixed asset purchase, this program may be right for you.
Through this program, you can borrow up to $5 million dollars to use for the purchase of large equipment, the purchase or renovation of a building, or to make land improvements. With this type of loan, repayment terms can be up to 20 years and interest rates are determined by current treasury rates.
This program is the most highly regulated type of SBA loan and also the hardest to qualify for. You will need a long and strong business credit history to qualify for a CDC/504 loan.
Business Lines of Credit
If you’re looking for the most flexible debt financing option, look no further than a business line of credit. This type of loan gives you money to serve a variety of your business needs.
Once you establish your line of credit, you can use it very much like you would a credit card. You can use the money for pretty much any business need including purchasing inventory, paying off other debts, and handling cash flows.
You only have to borrow as much as you need and once you pay back what you’ve borrowed the amount is immediately available to be borrowed again.
Businesses often have trouble with clients making late payments. When clients don’t pay their invoices, your cash flow can take a hit.
Invoicing financing is a type of debt financing where lenders buy your accounts receivable. This type of financing is also called accounts receivable financing.
When you sell your accounts receivable, you’ll receive a cash advantage of the majority of the value of your invoices. When your invoices are repaid, you’ll receive the rest of the money you were owed based on what was actually repaid minus a debt financing fee.
Equipment loans are a convenient way to purchase equipment including vehicles, machinery, computers and more. This type of loan is similar to a car loan because the equipment itself is your collateral for the loan.
If you don’t repay your loan, your lender will seize the asset (your equipment). This type of loan is a good option for those that don’t want to put up any separate collateral.
Merchant Cash Advance (MCA) is the Worst Type of Debt Financing
With a merchant cash advance, your lender will pay you a lump sum of liquid capital in exchange for a percentage of your future sales. The business will pay back the cash in addition to a fee.
The lender will automatically deduct a percentage of the company’s credit and debit card sales as repayment. This type of financing is best for seasonal businesses that need cash flow during their slower months.
These loans are easy to qualify for and fast but they require frequent repayment and can be expensive. It is best to stay away from this type of financing.
Choosing the Best Debt Financing Option for Your Business
As you can see, there are many different types of debt financing for businesses beyond the traditional bank loan. There’s a loan type for every business need.
It’s important to choose the type of loan that works best with your business’s goals and finances. We offer a variety of business loans to match your needs. It’s free to apply and easy to get started.
We will guide you through the process and help you select the best type of debt financing for your business. Click here to get started by applying today!