Advantages and Disadvantages of Debt Financing

Access to capital is one of the biggest barriers small businesses face when looking to implement growth strategies.

That’s why it’s important to understand both the advantages and disadvantages of debt financing. A resounding truth in business is that it takes money to make money, but it takes low-cost money to last. But where will that money come from? There are lots of options.

Don’t let the word “debt” scare you. Essentially, debt financing is the act of raising capital by borrowing money from a lender or a bank. In return for a loan, creditors are then owed interest on the money borrowed.

Debt can be cost-effective, providing small businesses with the funds to stock up on inventory, hire additional employees, and purchase real estate or much-needed equipment. If you’re still not sure about the advantages of debt to grow your small business, take a look at the pros and cons.

Advantages of Debt Financing

You Won’t Give Up Business Ownership
To begin with, one major advantage of debt financing is that you won’t be giving up ownership of the business. When you take out a loan from a financial institution or alternative lender, you’re obligated to make the payments on time for the life of the loan, that’s it. In contrast, if you give up equity in the form of stock in exchange for funding, you might find yourself unhappy about input from outside parties regarding the future of your business.

There are Tax Deductions
A strong advantage of debt financing is the tax deductions. Classified as a business expense, the principal and interest payment on that debt may be deducted from your business income taxes. Pro tip: always check with a tax professional or other financial planner to help answer specific questions about how debt affects your taxes.

Low Interest Rates are Available
Credit cards, peer-to-peer lending, short-term loans, and other debt financing isn’t helpful if the interest rates are sky-high. However, there is good news. A Small Business Administration (SBA) loan is a great option for low-cost funds. With long terms and low rates, an SBA loan is the gold standard for low-cost financing. If you don’t qualify for an SBA loan, there are plenty of other options out there. Just be mindful of the true cost of that loan. Work with a lender who practices complete transparency so you don’t get trapped in a cycle of borrowing. Understand your total payment, both interest and amortization. A good rule of thumb is if you typically have more than one payment per month or if the payment calculation is overly complicated, beware and take care not to move forward.

SEE ALSO: How To Get Small Business Loans With Bad Credit

You’ll Establish and Build Business Credit
The Global Entrepreneurship Monitor report, produced by Babson College and other universities, found that one of the top reasons for discontinuing a business in the U.S. were problems obtaining financing. Stellar business credit is crucial if you’re seeking low-cost, long-term debt funding. Therefore, having the ability to build your business credit is a major and crucial advantage to taking out a loan. When you build your small business’ credit, you reduce the need to rely on your personal credit or other high-cost business financing options. Good business credit can also help you establish more favorable terms with vendors.

Debt Can Fuel Growth
Uses of long-term debt include buying inventory or equipment, hiring new workers, and increasing marketing. Taking out a low-interest, long-term loan can give your company working capital needed to keep running smoothly and profitably year round. Think of it as the difference of being able to go that extra mile in your business and make additional profits, opposed to being tied down to a cash-strapped venture that will never be able to get ahead.

Debt Financing Can Save A Small Business Big Money
Often, small business owners rely on expensive debt – like credit cards, cash advances or lines of credit – to get their business off the ground. This type of debt cuts into cash flow and can hinder day-to-day operations. A big advantage of debt financing is the ability to pay off high-cost debt, reducing monthly payments by hundreds or even thousands of dollars. Reducing your cost of capital boosts business cash flow.

Long-term Debt Can Eliminate Reliance on Expensive Debt
There are lenders who use aggressive sales tactics to get businesses to take out short-term cash advances. Some businesses in need of funds will take five or six cash advances in a row. This strategy can trap a borrower into a debt cycle with no end in site. Instead, look to get an SBA loan. SBA loans have low interest rates, long terms, and low monthly payments. SBA loans can be used to help free small business owners from borrowing traps.

SEE ALSO: How to Apply for a Business Credit Card — And Get Approved

The Drawbacks of Debt Financing

You Must Repay the Lender (even if your business goes bust)
When you work with a lender, the rules are pretty clear: You must pay back the loan at the terms agreed upon. That means, even if your business goes under, you still have to make payments. Since most lenders require you to guarantee the loan, your assets could be sold to satisfy your debt.

High Rates
Unfortunately, predatory lenders exist and the techniques they use to rope in unsuspecting small business owners are getting more and more sophisticated. It’s definitely not an advantage of debt financing, but it is something to be aware of. Instead of disclosing the true cost of a loan, some unscrupulous lenders will use methods other than APR. Make sure you are working with a lender who practices transparency and will give you honest numbers. Know both your loan APR and your loan payment and compare it to your original balance.

It Impacts Your Credit Rating
Each loan you take out for your small business will be noted on your credit rating. Beware; this can cause your scores to drop. So before you apply for a loan, check with your lender to determine if the credit check performed to prequalify will affect your score.

You’ll Need Collateral
One of the “5 Cs” of lending is collateral. The SBA defines collateral as an additional form of security that can be used to assure a lender that you have a second source of loan repayment. If an asset can be sold by the bank for cash, it’s considered collateral. Items like equipment, buildings and (in some cases) inventory qualify. Collateral reduces the risk to a lender and is required for many types of loans. The amount of collateral a borrower has to put up is usually related to the size of the loan. Often, this is seen as a negative by some borrowers.

If you’ve decided that extra funds can take your business to the next level, it’s important to examine the advantages of debt financing. Remember that all debt is not created equal. So, strive to maintain strong credit scores so that you can get the lowest APR and the longest terms — ultimately, ensuring the health and longevity of your business.

Leo Jacobo

Leo Jacobo is the VP, Head of Lending Operations for SmartBiz Loans™. He is responsible for lending operations, inside sales, alternative financing partnerships, and overall loan volume production as well as personnel training, processing, and closing of all loans.