As the adage goes, "it takes money to make money."
Debt financing provides business owners with the opportunity to invest in new equipment, additional employees, and pretty much any other operational necessity that arises.
That being said, it’s crucial to have a firm grasp on how your initial investment will improve your bottom line.
36 percent of U.S. small business owners who’ve borrowed funds are "very or somewhat" uncomfortable with their debt load, according to a Gallup poll. The poll also found that 49 percent of those small business owners say it’s "extremely difficult" to pay down their current debt.
This article will explore the different types of business debt, how to conduct an ROI analysis, the concept of good debt, prepayment penalties, and finally how to pay off business debt.
Common types of small business debt
SBA loans and grants from the U.S. Small Business Administration (SBA)provide various government-based loan types that include general loans, disaster loans, microloans, and real estate and equipment loans. The Annual Percentage Rate (APR) is often among the lowest available. For example, a general small business loan, called 7(a), has an APR between 6.5 percent and 8.5 percent as of June 2017, NerdWallet reports. But SBA loans can be difficult to obtain.
Small business term loans are repaid, with interest, over a specified time period. Approvals can be fast and may not require collateral. But you could face a relatively short repayment term (say, 36 months or less). As is often the case, your APR can vary, depending on the lender, the amount borrowed, and so on.
Small business lines of credit differ from loans. With a line of credit, you’re approved for a specific dollar amount, which you draw from as needed. A loan, by comparison, is for a lump sum up front. Another advantage to a line of credit is that you only pay interest on what you’ve borrowed. The APR can fluctuate, however, while a loan’s APR is usually set, and rates may be higher than a term loan’s rate. Also, you may pay a small fee, such as 1 percent to 3 percent, whenever you borrow from the line.
Small business credit cards are a popular way to buy now, pay later. As with consumer credit cards, small business credit cards are available from a variety of financial institutions. Some cards offer cash-back rewards, others give you travel perks, and so on. It helps to shop around and compare cards at NerdWallet, Money Crashers, and The Simple Dollar.
Conducting an ROI analysis of the growth opportunity can help you decide if taking on debt is the right move.
Business Debt ROI
In determining whether taking on debt makes sense, business owners should look beyond just the cost of capital and consider the ROI (return on investment).
ROI is a measure of the gain accrued from a specific investment, relative to its cost.
ROI helps you determine the value a growth opportunity adds to your business. It’s calculated as:
(Gain from Investment - Cost of Investment) / Cost of Investment
You’ll also need to be sure to factor in the APR, which is the total interest payable on the loan, on a yearly basis, averaged over the duration of the loan. This is inclusive of fees and service charges.
When looking at ROI, business owners can make decisions more strategically by evaluating potential growth rather than only looking at costs one-dimensionally.
Is there good debt?
When you hear the word debt, you may cringe because it is a reminder of an obligation and payment that you have to make until you have cleared what you owe. However, your relationship with debt doesn't have to involve dread. Instead, think about how debt has its place in your small business in certain situations.
Bootstrap your startup
I am one of many entrepreneurs out there who bootstrapped their business and used savings and some debt to launch my first business. I wasn't entering a business where I felt I needed a ton of capital so a bank loan and venture capital was out.
Instead, I used small loans and credit cards to provide additional funds to help with some of my startup expenses. In doing so, I ensured I could get as much as possible for as little money or debt. In this way, I covered the cost of equipment and some basic operating costs until I started making some money. This made my savings go farther as well.
Improves business credit score
If you have a low credit score from never using any credit prior, debt can be good if you take some out and repay it before the due date. Continuing to make small purchases on credit can then establish and improve your business credit score. This strategy will help you take our more credit in the future should you need to make a larger purchase.
Helps you expand
Like your initial development, debt can also be good when it helps you get to the next level of business growth. Again, this is a point where you don't necessarily need a large sum of money. While you might be able to attract investor attention, it is better to continue bootstrapping your business to manage the company's financial position.
A line of credit or credit cards can help to purchase additional equipment, bring in more talent, expand your manufacturing relationships and even cover physical space for that expansion. The expansion will bring in additional revenue that can then help you get that debt paid back quickly.
Manages seasonal changes
Even though you plan appropriately for slow periods due to having a seasonal business, it still may be necessary to leverage a small amount of debt to see you through and prepare for the next round of sales.
Loan prepayment penalties
Unfortunately, as nice as getting rid of loan payments sounds, sometimes paying it off early can actually cost you more and result in a loan prepayment penalty.
What is prepayment penalty?
Always be sure to read the fine print of your loan agreement. What you may have missed the first time around is that your loan comes with a prepayment fee or prepayment penalty. This is something borrowers sometimes include in their loan terms as a way of deterring borrowers from paying off their debt early.
The reason: loans don’t come free. They come stacked with interest, and that interest is how lenders make money off their lending services. For instance, if you take out a 12-month loan, and decide to pay it off after just four months, the lender is missing out on eight months of interest. This is why some lenders will charge prepayment penalties.
It’s important to know what type of penalty your lender charges:
The flat rate
With a flat rate prepayment penalty or fee, lenders charge you a lump sum if you pay your loan off early. Typically they’ll determine the amount of the penalty based upon the terms of your loan. For instance, the lender may decide that for three-year loan, you’ll have to pay six months worth of interest.
If this is the type of penalty attached to your loan, there is a small silver lining. It can be easy to figure out what your penalty will be, thereby making it easy for you to figure out if prepaying off your debt will help you or hurt you.
The percentage penalty
Plain and simple—with a percentage penalty, you’ll be required to pay a percentage of your remaining balance in order to settle up with the lender in a small business debt settlement. For example, you might have a 20 percent prepayment on $5,000, which means you’ll pay $1,000 on top of your remaining balance.
If you have a reducing penalty attached to the terms of your loan you may luck out—depending on when you choose to pay off your loan, that is. Since this penalty is calculated on a sliding scale, the penalty will change depending on how far along you are in the terms of your loan.
Reducing penalties are typically found on longer-term, fixed-rate loans.
Short-term prepayment penalties
Short-term prepayment penalties tend to be a little trickier than the ones we’ve listed above. The reason behind this is because, although a lender may not be planning to forgive you of any interest, they may not actually list any prepayment fee in their loan agreement.
Basically, because short-term loans don’t amortize, the line isn’t clear between whether payments you’re making are on interest or principal. In these cases, the full amount of interest applies from day one of the loan—so you’ll pay the full interest amount regardless of when you choose to pay off your loan.
There are a number of reasons you may want to pay your loan off early, but if saving money is one of them, you’ll want to know what penalty—if any— is actually attached to your loan.
How to pay off business debt
Start with the big picture
Are you getting the best possible return on investment (ROI) from your operations and sales? Are you (or employees) spending too much time on minor activities that don’t lead to revenue? Try to wring as much inefficiency out of your operations as possible, so you and employees can focus more on tasks that will help increase capital flow. True, this won’t get you out of debt per se, but it will help your business be more profitable.
Refresh (or start) your small business budget.
Where’s the money going? What can be cut with minimal or no impact to your operations? What’s essential and what’s "nice to have"? By finding expenses to cut, you can put more income toward debt reduction.
Delay big expenses wherever possible.
Do you really need new tablets for your mobile workers? Whenever possible, push big-ticket purchases out at least a few months. Use that money, instead, toward paying down debt.
Follow the "stack" or "snowball" method.
There are two main debt payoff strategies: the stack and snowball methods. With the stack method, you identify the loan, line of credit, or credit card with the highest APR. Focus on paying that off first, with the biggest monthly payments you can afford. Pay only the minimum amount on the others. Once you pay off the biggest APR credit, focus on the next biggest, and so on. The advantage: You’ll save interest charges over time.
With the snowball approach, you focus on paying off the debt with the lowest balance, regardless of the APR. Once that’s paid off, focus on the next one. While the snowball method costs more in interest charges, you get the satisfaction of paying off a debt more quickly.
If possible, consolidate loans, credit cards, and other debts into one monthly payment. You may be able to pay less interest over time, too. Talk to a business debt relief company to find out your options. Intuit offers tips on small business debt consolidation, as does NerdWallet, and National Debt Relief.