From expanding product and services lines to dealing with short-term cash shortages, there are various reasons that small businesses seek to borrow money. Still, it’s important to realize that not all types of loans are created equal. Before you approach a lending institution, it’s important to assess your reasons for pursuing the loan and determine which funding type best suits your needs.
One option is the short-term loan, which provides borrowers with set quantities of cash to be paid back over predetermined periods. Like traditional loans, short-term loans require applicants to pay interest on the principal advance, and usually involve smaller cash sums and shorter repayment periods. In fact, most short-term loans reach maturity in less than a year, compared with long-term loans that may last for decades.
Additionally, short-term loans are often easier to obtain than their traditional counterparts. While larger banks provide most of the traditional loans in this country, entrepreneurs can secure short-term loans through smaller banks and lenders like credit unions. As a result, the lending criteria for short-term loans tend to be less stringent.
What Is a Short-Term Loan Good For?
Of course, not all business expenses are appropriate for short-term loans. In fact, companies that use short-term loans for long-term debts like real estate and business acquisitions may wind up suffering serious financial hardships down the line. Here are a few reasons that small businesses may want to pursue short-term loans over other lending types.
Cash Flow Issues
If your business has a cyclical or uneven sales structure, short-term loans may be ideal for resolving cash-flow shortages. For example, many new businesses struggle to find the funding for supplier bills and other expenses. By taking out short-term loans, companies can avoid running up their credit cards while waiting for the next revenue stream. Additionally, short-term loans can help businesses pay upcoming taxes so they don’t run into issues with the IRS.
Similarly, short-term loans enable businesses to keep up with seasonal trends. Many businesses require extra capital and staffing during the holiday season. A short-term loan enables a business to build up its inventory and cover temporary workers’ salaries in preparation for the holiday shopping rush.
Another common reason to take out a short-term loan is to finance an expansion. Whether you’re opening a second store or just broadening your product or service line, expansion requires upfront capital. With short-term loans, businesses can get that capital.
It doesn’t matter how good your business insurance is; every now and then a situation will arise for which your company is unprepared. With short-term loans, businesses can avoid going under in the event of an equipment breakdown, computer crash or natural disaster.
Pros and Cons of Short-term Loans
Loans can help take your company from startup to successful small business. However, not all funding types are equally useful. Review the pros and cons of short-term loans to decide whether this financing source truly meets your organization’s needs. The following are advantages of using short-term loans over other lending types.
Proponents of short-term lending appreciate the fact that it keeps companies out of debt in the long-term. Because short-term loans tend to mature within a year, borrowers can rest assured knowing they won’t be making payments forever. Additionally, the limited funding source ensures businesses will be responsible with their spending.
If your business has poor credit, taking out a short-term loan can be an effective way of boosting your score. Because most short-term loans must be repaid within a few months, borrowers tend to see a fast improvement in their credit. Once you’ve raised your score, you can take out a new loan at a more favorable interest rate.
Of course, short-term loans have a negative side as well. Here are some of the drawbacks associated with this type of funding.
Higher Interest Rates
In a healthy economy, short-term loans tend to have higher interest rates than their long-term counterparts. When setting loan rates, lenders start with the prime interest rate and add a premium based on the degree of risk associated with your company. It’s important to note that short-term rates tend to drop when the economy enters a recession. Additionally, borrowers who fail to pay back long-term loans in a timely fashion may end up paying more in interest overall.
Increased company spending is another side effect associated with short-term loans. Because short-term loans are more accessible than their long-term counterparts, borrowers may be tempted to take them out whenever they want an influx of cash. As a result, businesses can get into the bad habit of spending more money than they have in their coffers.
From lines of credit to loans both long-term and short, there are various methods of funding a business venture. Do your research to determine which lending type will help you meet your business goals.
If you’re looking for ways to access capital while keeping your debt to a minimum, here are five simple ways to reduce small business debt.
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