How to Bridge the Gap for Your Business' Finances
How Short-Term Business Loans Work & When to Get One
Are you in need of quick cash for your small business? In a pinch, a short-term business loan might be just the boost your company needs to grow. It can bridge the gap of needing to pay your suppliers while waiting to be paid by your customers, as well as help pay for seasonal hires or allow you to take advantage of a quick opportunity to expand sales. But these loans can also be costly and risky, leading to an endless cycle of crushing debt. Read on to learn the benefits and pitfalls of these increasingly popular loans.
When Should You Take Out a Short-Term Business Loan?
It's always better to plan ahead than to seek out quick cash under pressure. In addition to paying more for a short-term loan, you may find it hard to get approved if your business is already in trouble. Ideally, you will establish a business line of credit with your lender before you required it. Still, there are times when a short-term business loan may make sense.
7 Times a Short-Term Loan Can Be Useful
Buying supplies to fulfill a large, unanticipated order
Hiring temporary workers to handle increased seasonal demand
Covering a tax shortfall
Repairing or replacing an unexpected equipment failure
Taking advantage of an immediate opportunity to expand your business
Refinancing other short-term debts at a more favorable term
Financing a short-term marketing campaign
But if you find yourself regularly scrambling to get a short-term loan to cover ongoing business expenses, it's probably time to reevaluate your business plan. Because the interest rates are higher, and payments are due more frequently, these loans can be risky for a business without a guaranteed source of revenue. Missed payments can lead to skyrocketing fees and interest. In short, these loans are too expensive to rely on for regular working capital throughout the year.
How Short-Term Business Loans Work
Short-term business loans differ from traditional loans in a few important ways, including a faster approval time, a shorter repayment period, more frequent payments, and higher interest rates.
Quick Approval Time
Depending on your lender, approval time can range from as little as 24 hours with some online lenders, to a few weeks with traditional financial institutions. They will generally ask you to provide information about your business and revenues, your credit record, and the purpose of your funding. This will help to determine the best type of loan for you, as well as your interest rate and fees. Short-term loans often don't require collateral, whereas intermediate or long-term loans often do.
Shorter Repayment Terms
Short-term loans are usually repaid within a year, according to the SBA, but some lenders offer them for up to 36 or 48 months. They are also usually repaid on a daily basis (instead of a typical monthly repayment plan for a traditional loan). It is important to consider your revenue stream and whether you will be able to handle the daily repayment schedule.
Higher Interest Rates
Interest rates are higher on short-term loans and are often expressed in different ways compared to the typical Annual Percentage Rate (APR) of a traditional loan. Two common ways of stating the interest you will pay are:
Total Interest Percentage (TIP): This is the amount of interest you will pay during the life of the loan.
Factor Rate: This rate, multiplied by your loan, is the total amount of money you will have to repay (excluding fees). Factor rates usually range from about 1.1 to 1.5 on short-term loans, depending on your creditworthiness.
Here are a couple of examples of how these rates work on a typical short-term loan:
Kate takes out a six-month, $50,000 loan with a TIP of 9 percent. This means she will pay back a total of $54,500 (plus fees). Assuming she has a daily repayment schedule, and there are 22 payment days in a month, she will have to make 132 payments of $412.88 in order to pay the loan back within six months.
Larry takes out a one-year $100,000 loan with a factor rate of 1.18. This means he will pay back a total of $118,000 (plus fees). Assuming a daily repayment schedule, he will make 264 payments of $446.97 over the course of a year.
These loans require a constant, predictable revenue source with which you can make payments. It's important that you have a reliable income stream if you plan to take out such a loan. If you miss a payment, your rates can quickly become overwhelming.
Other Types of Short-Term Business Financing
There are several different options for short-term credit and types of lenders. The best fit for your business will depend on the nature of your expenses, as well as your credit history and revenues.
Line of Credit
Perhaps the easiest and most cost-effective type of short-term financing comes in the form of a line of credit with your bank. The line of credit is connected to your account, and any withdrawals you make will be repaid via transfer from your account. It's best to set this up in advance so that it is available when needed. But even if you don't have one established in advance, you can often set one up faster than a traditional loan. This is a relatively low-cost and convenient way of securing cash quickly and you only withdraw what you need.
These are short-term loans to "bridge" the gap between expenses and anticipated revenue. They could be used to cover a short period before your long-term financing comes in or between paying for supplies and receiving payment for an order.
Working Capital Loans
These loans are used to keep your business "working" - whether that is to purchase inventory, fund payroll, or repair equipment.
Types of Short-Term Lenders
Depending on the size, nature, and creditworthiness of your business, you may be able to access a short-term business loan from several different types of lenders:
Traditional Banks, Credit Unions, and Community Development Banks
These institutions typically provide a line of credit or a bridge loan to larger, more established, and creditworthy businesses. These more traditional financial institutions will usually offer the best terms and interest rates, but it is hard for many businesses to qualify. It can also be time-consuming: small businesses spend an average of about 25 hours filling out paperwork for a bank loan, according to research from the Federal Reserve Bank of New York. Then they often have to wait weeks for the loan to be approved and dispersed.
An increasingly popular option for businesses that need quick cash and have a decent (if not great) credit history. They will often charge a higher interest rate than a traditional lender but are usually much faster and more efficient. With an online lender, you can often fill out an application online in less than 30 minutes, be approved within hours, and receive your money within days.
Merchant Cash Advance Lenders
Similar to "payday lenders" for individuals, merchant cash advance (MCA) lenders tend to loan money to businesses with poor credit history at the highest interest rates. In exchange for quick cash, you agree to pay the lender a portion of your credit card receipts every day until the advance is paid off. Experts warn the industry is poorly regulated and these cash advances usually come with hidden fees and sky-high interest rates, so do your homework.
How Do You Qualify for a Short-Term Loan?
Traditional financial institutions, online lenders, and merchant cash advance lenders all have different requirements to qualify for a loan. The better your credit score, the higher your revenues, the longer your track record, and the broader your customer base, the better your loan terms and interest rates will be.
If your credit score is under 650, you are unlikely to get a traditional loan from the bank. You may be eligible for a loan from an online lender. Online lender OnDeck, for example, requires a minimum credit rating of 600, but it has reported that the average credit score of its borrowers is actually 690. Whatever the eligibility requirement, rest assured that the higher your credit rating, the better your loan terms will be.
Your lender will want to see a business track record. Banks will be especially interested in this, but even some online lenders require that you have been in business for at least one year.
Many lenders will want to see that you have a stable revenue source. OnDeck, for example, requires that businesses have at least $100,000 in gross annual revenue. The SBA recommends that you develop revenue projections for the next five years before seeking funding.
- What are the pros and cons of taking out a short-term loan?
- What options are available for short-term business loans?
- Is it safe to use an online lender?
- How can I tell whether a short-term loan is the best option for me?
Director, Alameda County Small Business Development Center
Business Instructor at Central Carolina Community College
President and CEO of University Credit Union
SBA Learning Center Here you can find free online tutorials to assist in every area of your business, including how to find appropriate financing.
SCORE A network of small business mentors with years of entrepreneurial experience, available to counsel small businesses.
Small Business Development Centers These centers, funded through the SBA, offer a wide range of training and counseling services for local businesses. You can search for one in your area by entering your location here.
Criteria to Qualify for a Small Business Loan Online lender Fundera offers this free guide to eligibility requirements for different types of business loans.
National Federation of Independent Businesses (NFIB) A national association of over 325,000 small businesses.
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