4 Types of Debt Financing for Small Business

Looking to expand your business with additional funds? You can use debt financing successfully for a variety of purposes, from marketing to equipment purchases and everything in between. Here are some of the most popular options.

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What is debt financing?

Debt financing is the process of borrowing funds from a lender in order to raise business capital. The borrower then repays the sum in regular installments, typically with interest. This financing can be used for a variety of purposes at all stages of a business’s growth.

How debt financing works

Funds are borrowed from a lender with a set payback period. Terms and rates vary and business owners are encouraged to review all options available and work with a financial professional to choose the right financing.

Long-term vs. short-term debt financing

1. Long-term debt financing (unsecured and secured)

Other types of long-term debt financing can come in two different forms: unsecured and secured. The difference lies in whether collateral is required. Typically, loans not secured with collateral will only be available to applicants with excellent personal credit. In most cases, lenders will request some form of collateral to protect the loan in case of default.

Secured debt financing, on the other hand, does require collateral as part of the application process. Because of the extra security in the form of collateral, they may approve borrowers with slightly lower credit scores since their risk is minimized.

2. Short-term debt financing

Short-term debt has to be repaid sooner than long-term loans. Typically, these range from several months to a few years. Because of the shorter timeframe, there are usually higher interest rates associated with this type of financing.

Credit cards, lines of credit and cash advances, all fall under this category. These options may be revolving, meaning that you can continue withdrawing funds as necessary up to a certain limit. Unlike installment loans, which can be either short-term or long-term, you don’t have to reapply once you’ve paid down some set amount.

Sources and types of debt financing

1. Loans from family and friends

One of the safest ways to fundraise for your small business is to refer to the friends and family you trust. If you treat the process professionally, set realistic milestones, and create thorough documentation, you can have access to secure funds on your terms. Don’t take the agreement lightly though, because not only are funds at stake, but personal relationships too.

2. Bank loans

A Bank Term loan from lenders in the SmartBiz network is a short-term, fixed-rate loan with stable monthly payments. These loans are a great fit when you need funds quickly and want to lock in your interest rate. The same streamlined process SmartBiz uses for SBA loans is used for term loans.

Proceeds from a Bank term loan can be used in a variety of ways to meet your business goals. Funds can be used for working capital, debt refinance, new equipment purchase, and more. Additionally, paying off a Bank Term loan responsibly helps to build business credit.

3. Personal loans

A personal loan is funding borrowed from a bank, credit union or online lender. These loans can be used for any number of purposes, including funding a business. Most personal loans are unsecured, which means they don’t require collateral. They are typically paid back in fixed monthly payments, usually over two to five years.

As long as your lender has no restrictions against using a personal loan for your business, you can use the money for various business building initiatives like equipment purchases, marketing, or other costs you incur when starting a business.

4. Government-backed loans, such as SBA loans

If you can qualify, an SBA 7(a) loan is generally the best option for working capital. The 7(a) Loan Program is the Small Business Administration’s primary program for helping small businesses with financing. The SBA does not actually make direct loans; instead, it provides loan guarantees, promising the bank to pay back a certain percentage of your loan if you are unable to.

Frequently seen as the “gold standard” in small business loans, an SBA loan might have the longest-terms (10 years) and lowest-interest available in the marketplace. SBA lenders look for established businesses and applicants with good credit, a solid business plan, collateral, and a demonstrated ability to repay the loan. In addition to working capital, SBA 7(a) loans can be used for debt refinance and commercial property purchase or refinance.

5. Lines of credit

An outright loan is a lump sum of borrowed money, but a business line of credit is a revolving line you can draw against as you need it. You only pay for the money that you use. Lines of credit can be extended by a large bank, a small local bank or an alternative online lender.

Lines of credit have advantages over regular business loans. The use of funds is flexible, there are no set monthly payments and no interest is charged on the unused money in the account. When you repay a borrowed amount, those funds are immediately available again.

Some lines of credit have a draw period. This is an amount of time you can withdraw funds. For instance, a 2-year draw period allows you to withdraw money for a period of 2 years. Learn more: Lines of Credit: Pros and Cons.

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6. Credit cards

A business credit card is intended for use by a business rather than for an individual's personal use. Business credit cards are available to businesses of all sizes. They can help businesses build a credit profile to improve future credit borrowing terms. Read The Pros and Cons of Credit Cards for more information.

7. Equipment loans

Business equipment loans are used for acquiring larger equipment that might be too pricey to expense outright. Whether it’s new computers for the office, heavy machinery, or anything in between, the tool you're planning to purchase will usually act as collateral for its own loan.

Review Are Equipment Loans Good for a Small Business?

8. Commercial real estate loans

With long terms and low rates, SBA 7(a) Commercial Real Estate loans offered from banks in the SmartBiz network are a great option for small businesses looking to refinance an existing commercial real estate mortgage, or buy an office building or other owner-occupied commercial space.

9. Personal Loans from Family and Friends

One of the safest ways to fundraise for your small business is to refer to the friends and family you trust. If you treat the process professionally, set realistic milestones, and create thorough documentation, you can have access to secure funds on your terms. Don’t take the agreement lightly though, because not only are funds at stake, but personal relationships too.

Pros and cons of debt financing

Pros:

  • Maintain ownership: You become obligated to make the agreed-upon payments on time when you borrow from the bank or another lender, but that's the end of your obligation. You retain the right to run your business however you choose without outside interference.
  • Tax deductions: This is a huge attraction for debt financing. In most cases, the principal and interest payments on a business loan are classified as business expenses, and they can, therefore, be deducted from your business's income at tax time. It helps to think of the government as a “partner” in your business in this case, with a 30% ownership stake or whatever your business tax rate is.
  • Lower interest rate: Analyze the impact of tax deductions on the bank interest rate. If the bank is charging you 10% for your loan and the government taxes you at 30%, there's an advantage to taking a loan you can deduct.

Cons

  • Repayment: Your sole obligation to the lender is to make your payments, but you'll still have to make those payments even if your business fails. And your lenders will have a claim for repayment before any equity investors if you're forced into bankruptcy.
  • High rates: Even after calculating the discounted interest rate from your tax deductions, you might still be faced with a high-interest rate because these will vary with macroeconomic conditions, your history with the banks, your business credit rating and your personal credit history.
  • Impacts on your credit rating: It might seem attractive to keep bringing on debt when your firm needs money, a practice knowing as “levering up,” but each loan will be noted on your credit report and will affect your credit rating. The more you borrow, the higher the risk becomes to the lender so you'll pay a higher interest rate on each subsequent loan.
  • Cash and collateral: Even if you plan to use the loan to invest in an important asset, you’ll have to be sure that your business will generate sufficient cash flow by the time repayment of the loan is scheduled to begin. You’ll also most likely be asked to put up collateral to protect the lender in the event that you default on your payments.

How to choose the right debt financing for your business

Although the options may seem overwhelming, with a little research and advice from a financial professional, you can find the right option for your unique business.

2020 has been extremely challenging with the coronavirus pandemic and economic downturn deeply affecting small businesses as well as the overall U.S. population. Outside funding can be a life-saver for businesses looking to rebuild or improve business performance in 2021.

* The information provided through SmartBiz Advisor, including the Loan Ready Score, is for educational purposes and is not the same as scores used by lenders for credit decisions. SmartBiz Advisor is not a financial or legal advisor as defined under federal or state law. Use of this information is not a replacement for personal, professional advice or assistance regarding your finances or credit history.

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