Shopping for Small Business Loans
Nick Clements
Monday, October 12, 2015
Obtaining financing for a small business can be challenging and confusing. Most banks only want to deal with businesses that have more than $2 million of annual revenue. If you do not generate that much revenue, the most common way to borrow has been with small business credit cards. Credit cards can be a great deal in certain circumstances. However, there are also some very significant limitations.
Small business credit cards are great for businesses that have limited borrowing needs. With a credit card, no interest accrues if you pay your statement balance in full, taking advantage of the grace period. For example, if you have an online business and need to pay for Google AdWords, a credit card could be a great solution if you receive payment quickly for your product or services. You can even earn cash back or rewards on your spending. However, there are some real limitations that you need to consider. First, it will be difficult to get a big credit limit. Credit card companies generally use automated underwriting to establish a credit limit. Because it is an algorithm looking at your personal credit score and your company credit report, the bank will not be willing to take a big credit risk. Big loans are usually only given after a bank reviews your income statement, cash flow and often visits your business. And most big banks don’t want to do all that work for a small company.
The second big issue is that small business credit cards are not subject to many of the protections of the CARD Act. That means your interest rate could be increased on your existing balance at any time. Risk-based re-pricing is still legal. If a bank’s credit risk model thinks your risk profile has deteriorated, it can increase your interest rate, increasing your payment overnight. You do not have to miss payments to have a riskier profile. Just building up balances on your cards may be enough to get you into trouble.
The third big risk for credit cards is that you are taking a personal liability. Although the balance of your small business credit card will not be reported to the credit bureau while you are current, the situation changes dramatically once you miss a payment. Typically, once you become 60 days past due, your small business credit card information would be reported on your personal credit report. If your business goes bankrupt, you will still be personally liable for the debt on your small business credit card.
Small business credit cards offer the best deal when you pay your statement balance in full and on time every month. However, you should take a close look at the interest rate on your credit card. If your business generates less than $2 million of revenue, it will be difficult to get a very low interest rate from most lenders. In many circumstances, borrowing on your credit card is a better deal than using one of the new marketplace lenders.
When Is A New Marketplace Lender Better For A Small Business Loan
There are three reasons when a new marketplace lender could be a better deal:
- You are approved by one of the leading providers, like Funding Circle. Some of the marketplace lenders are truly offering competitive interest rates than can beat traditional credit cards.
- You need a lot of cash. Credit cards are great, but only where credit cards are accepted. The cash advance interest rate on cards can be high, and marketplace lenders can often beat that rate.
- You have a large borrowing need, particularly to invest in inventory or equipment. As discussed, the typical limit on credit cards is low. If you have the opportunity to make a big investment to help your business grow, a marketplace lender could be a great deal.
How To Increase Your Chances Of Being Approved
To increase the chances of your small business getting the best deal, you should follow a few simple steps.
- Make sure you create a separate legal entity for your business. For example, set up a Delaware LLC. If you don’t have an entity, you look like you are self-employed, rather than an employee of a small business.
- Make sure you have separate bank accounts for your small business. Far too many small business owners mingle their personal and business accounts. Set up a small business account at your community bank, and make sure that only business expenses go through that account.
- Pay yourself a salary, and don’t use the company as a piggy-bank. Lenders get very nervous if they see a co-mingling of personal and business assets.
- Generate financial statements monthly, and use an online resource like QuickBooks. Far too many people only generate an income statement once a year, at tax time. You need a regular set of books, and there are easy ways to find very low-cost QuickBooks experts who can help keep your accounts in order.
- Create a social media presence. Your company should have a LinkedIn page. If you have a consumer-facing business, you should have a Yelp presence as well. The new lenders look at this information.
If you do all of the above, your chances of getting approved for a loan are greatly increased.
Most of the reputable lenders require at least a year of operations and some earnings. As a general rule, you should not try to borrow money before you have started generating cash flow that can be used to service the debt.
Risks To Borrowing
A lot of the small business marketplace lenders are extremely expensive. Many of the lenders charge 40% or higher interest rates. Even worse, it is difficult for many borrowers to understand the actual cost of their loan. Beware lenders that only quote fees, rather than annual interest rates.
You should really ask yourself a few questions.
First, do you need to borrow money all year? If every month you are going to repeat the same process, you should think about a long-term credit facility rather than a short-term solution.
Second, you should think about how long it will take before you can pay back the money. If you can pay back the loan every 20 days, a credit card is preferable. If it is going to take longer, a line of credit or personal loan could make a lot more sense.
Finally, make sure you include the cost of interest in your profitability calculations. A business may look lucrative, until you include the high interest expenses of many lenders. Just make sure you do the math, and look at your financial statements every month.
MagnifyMoney Recommendations
If you do not need to borrow a lot of money, and can repay the loan ever 20 days, you should consider a credit card. You can even earn 2% cash back from products like Capital One Spark.
If you are in a funding emergency, beware people offering very fast cash. It may solve a short-term problem, but you will only be digging yourself into a deeper hole. Most of the marketplace lenders offering quick money at high interest rates require a personal liability. The loan may help you make payroll this month, but you may only be getting yourself into more trouble. If your business can’t make money, it is better to make tough decisions now, rather than to take out expensive loans to keep the lights on. Far too many business owners get too attached to their businesses, and end up getting themselves into deeper financial problems because they are not willing to be honest with themselves when it matters. You might need to lower costs, restructure or even close down rather than take out a loan.
If you are looking to grow your business, and you have a good set of books, consider a provider like Funding Circle. They have low (often single-digits) interest rates and a commitment to helping businesses grow.
