We talk to a lot of business owners who want to borrow money, but are overwhelmed by or are unsure of the variety of lending options. In our previous post of this two-part series, we provided a simple three-step framework for thinking through whether borrowing money is the right tool for growing your company. Here, we’ll walk you through a few of the most common ways to borrow money and how to determine which one might be best for your business.
3 Most Common Ways to Borrow Money
While there are a wide variety options to consider, credit cards, merchant cash advance and term loans are three of the most common ways to borrow money for your business.
Most of you probably know about the credit card option, but may not have heard much about merchant cash advance or term loans. In a merchant cash advance, the provider offers you money and, in exchange, you agree to pay the advance plus predetermined fees by letting the provider take a portion of your credit or debit card sales each day until the entire amount has been paid. Term loans let you borrow money and pay it back over a fixed term, usually at a fixed interest rate.
Below, we break down the most important advantages and disadvantages to each method.
Credit Card Option
Advantages
- Simple to get: usually short, online applications.
- Flexible: you can draw down your business credit line and pay it back whenever you like (within certain minimums), which is great for shorter term or less defined needs.
Disadvantages
- High rates and fees: Business credit cards often come with interest rates in the high teens and additional fees.
- Reliant on credit: Approval is linked almost exclusively to business and/or personal credit.
Tips and Best Practices
Credit cards are a good option for companies that have shorter-term needs. Make sure you pay the minimum amount required each month to avoid late payment fees and try not to hold a large balance, since the rates are often high and can impact your business’s bottom line.
Merchant Cash Advance Option
Advantages
- Easy approval: The approval process is often fast and less dependent on credit scores.
- More flexible in downturns: MCA payments being tied to daily credit card receipts means that the payments will adjust to the success of your business. This will help you delay payment if you have a dip in sales.
Disadvantages
- High cost: MCAs usually have high fees that make them more expensive than loans or, in some cases, even credit cards.
- Doesn’t build credit: Unlike the other two options, paying back an MCA doesn’t build your business’s credit.
Tips and Best Practices
New businesses that have unpredictable performance and sell most of their products through credit card payments can use MCA to finance shorter-term projects. Make sure you fully understand all the fees involved, because an MCA doesn’t have an interest rate but usually has high fees.
Term Loan Option
Advantages
- Lower interest rates: Term loans often have interest rates starting in the single digits.
- Increased amounts: Depending on your business finances and available collateral, lenders will allow you to borrow up to millions of dollars in lending capital.
- More holistic approach: Some lenders consider additional business factors like financial health and projections, not just credit score.
Disadvantages
- Fixed payment schedule: Make sure you’re comfortable covering the fixed monthly payments given your business’s cash flow. Some lenders have a prepayment penalty too, but not all.
- Process can take time: Traditionally, applying for a term loan and getting a decision can take multiple weeks, as requirements are more stringent.
Tips and Best Practices
Term loans are great for more established companies looking to fund longer-term investments at a lower interest rate.
Online-based lenders (Bond Street as an example) often provide faster processes than traditional lenders: the loan application can take 15 minutes and a decision is usually made within a week.
The Real Cost of Borrowing Money
Now that you know about the different products, it’s important to think through whether or not borrowing will be cost efficient for your business. Different products have different interest rates and fees, so there isn’t really one measurement we can use to compare the true cost of borrowing.
Many people believe comparing interest rates is the best way to understand the cost of borrowing. However, interest rates do not take into account additional fees or the time period of the loan, and certain products like MCA don’t have an interest rate, but do have high fees. To accurately understand and compare the cost of borrowing, you need to calculate the annual percentage rate, or APR. APR represents the total cost of all that must be paid to borrow the money –– including interest and fees –– divided by the amount borrowed, and measured over a constant time period (annually). It provides a bottom line cost of borrowing number that you can use to compare different products and lenders, making it very helpful.
Though APR is calculated differently across products, all lenders should state the terms needed to calculate it, or quote APR directly (as in the case of credit card companies). The important thing to remember is that APR can be calculated for any debt product, and since it’s an annualized rate that includes all interest and fees, it can help you compare the true cost of your options, apples to apples.
Hopefully this post has helped you understand the different ways you can borrow money and when some products may be a better fit than others for your business. If you’re interested in learning more about your borrowing options, tell us a little bit about your business and we’ll get back to you soon with some helpful resources.
Photo: Flickr, Ken Teegardin
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