Debt Financing: Definition and Types
When your company needs funds, you have a variety of alternatives regarding how to obtain them. For example, to help your business grow, you could be tempted to employ invoice factoring, a merchant cash advance, a loan from a friend or family member, or a withdrawal from your retirement account. However, among the many choices for funding a business, debt finance is one of the most popular.
What Is Debt Financing and How Does It Work?
In its most basic loan form, debt finance is when you take out a loan to fund your business, which is subsequently returned over time with interest. In other words, most business owners would prefer debt financing as a business loan. It could be a short-term loan that you pay back in a few months or a long-term loan that you pay back over several years or decades, depending on the sort of loan you pick. Unlike equity financing, debt financing does not entail bringing on additional business partners or relinquishing any control over your company’s activities to a third party.
Mortgages on real estate, credit cards, bank loans, and even borrowing money from family and friends are all examples of debt financing. In essence, debt financing refers to financing that involves receiving money upfront and repaying it over time with interest. Each financing option has its own set of rates and terms, which are usually determined by your company’s eligibility criteria.
Debt Financing Types
There are a variety of debt financing solutions accessible. Your situation will determine which option is best for you and your company.
Short-Term Business Loans
Short-term loans may be a choice for businesses that don’t require a large sum of money. Unfortunately, many companies are turned down for business loans because they seek too little money for the lender to consider them profitable. Short-term loans, on the other hand, are frequently issued for lesser amounts of money and are suitable for dealing with temporary setbacks and short-term expansion initiatives because they typically have durations of a year or less.
Unsecured Business Loans
Large, long-term loans sometimes require the borrower to put up a significant asset as security, but unsecured business loans do not. However, keep in mind that an unsecured company loan indicates that the lender will not require a deposit to grant the loan. Therefore, if you default on an unsecured loan, the lender can still seize your assets to recoup their losses.
Many lenders consider small firms to be a higher risk, and they have a more challenging time obtaining loans approved. Therefore, the Small Business Administration will agree to guarantee a portion of business loans for eligible enterprises to encourage lenders to approve loans for small business owners. SBA loans come in various forms, including 7(a) loans, CDC/504 loans, microloans, and disaster loans.
Another alternative for firms in need of a small sum of money is a microloan. The typical amount for a microloan in the United States is between $10,000 and $13,000. Microloans are available to startups, very young enterprises, and businesses that have never borrowed money from a bank, unlike many other sources of company finance.
Merchant Cash Advance
Seasonal or changing income is common in small enterprises, making it difficult to keep up with fixed payments. A merchant cash advance is a cash advance in exchange for a proportion of future revenue or credit card sales. Merchant cash advances are available in various formats and typically have shorter terms and lower regular remittance amounts than company term loans, making them perfect for small business owners that require flexibility in repaying their advance.
Equipment finance allows business owners to borrow, lease, or loan hard assets such as machinery and other equipment for their company. Rather than paying for the purchases in full upfront, equipment financing allows you to have the gear you need now while paying for it over time. Equipment financing is available in various formats, with many of them being easier to qualify for than other types of debt finance.
Advantages and Disadvantages of Debt Financing
Like any other type of funding, debt financing has pros and cons.
Benefits of Debt Financing
While equity financing allows you to obtain cash for your business without going into debt, it also requires you to relinquish some control over your company. Even if you acquire debt, debt financing allows you to maintain complete control over your organization. However, taking on debt has its advantages, as properly repaying a business loan can help your company establish good credit.
Debt finance interest rates vary depending on the sort of loan you have. Long-term business loans have the lowest interest rates, but they are difficult to obtain and have the most stringent restrictions. On the other hand, short-term loans feature higher interest rates and are typically issued for smaller money. Still, they are easier to get and more accessible to many enterprises.
Some forms of debt financing are more challenging to get than others. For example, small and fledgling enterprises will struggle to obtain larger long-term business loans since they require higher credit scores, a proven track record, and possibly collateral, making them harder to obtain. On the other hand, many short-term loans have fewer restrictions on how long you’ve been in business and your company’s credit score.
Disadvantages of Debt Financing
Although debt financing does not require you to give up any control over your company, you risk losing important assets if you default on a secured loan. Unsecured business loans do not require collateral, but because they pose a greater risk to the lender, obtaining one is often more stringent, and the interest rates are higher than secured loans.
Making interest payments over time might eat into your revenues, and it will always be more expensive than funding your projects with your own money. However, you can explore new growth projects that take your organization to the next level without giving up equity by borrowing money and repaying it over time.
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