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Article · Jul 28, 2016

The pros and cons of short-term debt

Like all small business owners, you face important decisions every day. Should you take on that new client? Add that product to your portfolio? Hire that new employee? The list goes on.

For entrepreneurs in need of quick access to capital, one of the biggest questions will likely be whether to take on short-term debt. Short-term financing can help fund equipment, supplies, and labor. It can also help small business owners take advantage of new opportunities or help seasonal businesses purchase inventory to prepare for highest volume months.

Short-term debt can be a tricky issue. Overextending can mean paying a high cost to borrow funds—but without taking the risk, you could be sacrificing important opportunities to grow your business. There are some key decision criteria to examine when considering new financing options.

Pros and cons of short-term financing

Pro: Relaxed eligibility
Short-term lenders typically have more relaxed eligibility requirements than conventional banks or SBA loans do. This lets borrowers with damaged credit access much-needed sources of capital. For businesses shut out of the conventional lending market, short-term debt is often a lifeline.

Con: Higher interest rates
A short-term loan is almost always at a higher interest rate than a long-term loan—and often multiple times higher. Be sure to watch out for high interest rates.

Pro: Get approval in just hours or days
Businesses with immediate capital needs can usually secure short-term loans in a matter of hours or days. This stands in stark contrast to many conventional lenders, who often take weeks or months to close a deal.

Con: The high-cycle risk
You take out a short-term loan because you need the money. If cash flow is really tight, you run the risk of not being able to make the payments on that loan—which can mean needing another loan to make the original payment. You don’t want to get caught in a common and painful debt trap.

Pro: Quick payment plans no longer than 18 months
Short-term loans are, by definition, of limited duration—typically somewhere between three and 18 months. This means your short-term debt quickly gets cleared off your books, which is always comforting.

Con: Could be habit-forming
The easy availability and convenience of short-term loans often gets borrowers hooked towards opting for them whenever they need some money. While this is definitely convenient, you may actually wind up spending more than you can afford (or wasting money, if you could qualify for a lower-cost term loan elsewhere).

Pro: Less paperwork
Documentation requirements are much looser—often just a few months’ worth of bank statements. Busy entrepreneurs (or anyone who’s been through the arduous process of securing traditional bank financing) will appreciate this difference. By securing capital through a streamlined process that requires minimal paperwork, business owners can focus on day-to-day operations, instead of getting bogged down in financing details.

When short-term debt makes sense
Roughly 50% of businesses don’t make it past five years, so the acceptance of new risk is a serious question that each business owners must answer for themselves—relying on what they know about their tolerance for risk and their need to invest.

Loans, and especially short-term debt, can help small businesses get out of a cash- flow jam. Short-term debt is a resource that can make sense for businesses that generate daily revenue, assets that can bring in revenue quickly, or companies requiring capital for a revenue-creating opportunity such as a large pending order, a seasonal sales push, or essential equipment or inventory for a startup.

If you are in a position where failing to secure new capital will cost your company guaranteed revenue, a short-term loan is almost always a good choice. The money can be paid back quickly, with little-to-no risk.

Don’t rob Peter to pay Paul
On the other hand, taking out a short-term loan to meet long-term debt obligations (the old “robbing Peter to pay Paul” scenario) is less defensible. In general, short-term loans are best suited for situations where they can be directly tied to revenue.

Small businesses like yours are the lifeblood of the US economy, representing 99% of US companies, 54% of total sales and 55% of all jobs in the US, according to the US Small Business Administratio. Having access to capital, and making the best decisions possible, is crucial to small businesses’ continued success.

Good news on the horizon
According to Business Insider Intelligence's 2016 Small Business Alternative Lending Report, alternative small business lenders originated $5 billion in 2015, and will increase loan originations to $52 billion by 2020 to the small business lending market. The ten-fold surge in loan volume will be driven by the continued growth of new players, increased borrower awareness and interest, and major partnerships with big banks.

This is good news for small business owners looking for more suitable options to get them out of a jam, preferable to credit-card debt and the sometimes cumbersome process with big banks.

Bottom line: Always compare a range of loan offerings in order to determine the option that best fits your borrowing needs. Short-term debt can be the right fit for certain situations, but comes at a price. You want to make sure you’re getting the lowest-cost loan available to your business.

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Meredith Wood

Editor-in-Chief at Fundera

Meredith Wood is the Editor-in-Chief at Fundera, an online marketplace for small business financial solutions. Specializing in financial advice for small business owners, Meredith is a current and past contributor to Yahoo!, Amex OPEN Forum, Fox Business, SCORE, AllBusiness and more.

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