Successfully running a business requires money.
Securing financing and figuring out how much money is needed so you don’t miss opportunities for growth, intimidates many people out of becoming business owners in the first place. The constant need for money is one of the reasons why many people avoid starting businesses at all.
There are solutions, though. Like anything else you deal with in business, it’s about having the confidence and patience to figure out what will be the best option to meet your short term and long term financial goals.
When you need to borrow working capital for your small business, there are several options. Three of the most popular loans are; business term loans, business lines of credit, or financing from a merchant cash advance.
All of these options will provide cash for your business needs, and they’ll all need to be repaid, but they’re very different in the ways you borrow and need to repay them.
Let’s see how they all work, the main differences, and which one is right for your business’ needs.
How a Business Term Loan Works
A business term loan offers the borrower a lump sum of money that they then repay over a specific term. The payments are made regularly and most of the times at a fixed rate. These are often called Business term loans and can take anywhere from one to ten years to repay depending on the terms set at the time of financing.
They are similar to a car loan or a mortgage. Most often a business loan is amortized, which means the borrower pays the same amount monthly for the life of the loan.
There are loans with interest-only payments or balloon payments out there, but they are much less common. A business term loan will have an interest rate and the interest will need to be repaid as well as the principal amount.
On top of this, there are also other fees associated with the loan, most often these will include origination fees or processing fees. An origination fee can range from 0% to 4% of the amount borrowed.
Business loans are typically used to cover a large, one-time purchase. People prefer this type of financing because having a fixed interest rate with a fixed payment every month makes for predictable budgeting and less stress.
Business owners also choose small business term loans because it’s a convenient way to handle a large purchase, like for renovations or real estate.
How a Merchant Cash Advance Works
Similar to a loan, a merchant cash advance provider allows you to borrow a lump sum that you repay. This is very different financing in most other ways, though. This is more of an advance than a loan. The borrower gets a lump sum and then the amount is repaid through a percentage of your daily credit card receipts.
The percentage, called a holdback percentage, is a fixed rate. But the daily amount of credit card sales you have will fluctuate. So the amount you pay back every day will change, and that means this is a variable repayment term. It can take a few months to repay, or possibly a year and a half.
Another key difference is that you aren’t charged an interest rate. Instead, you will be charged a factor rate, which will typically fall between 1.1 to 1.5. This rate will be determined by factors like your industry, how long you’ve been in business, and how stable your company is.
For people with a seasonal business, where their income varies month to month, this can be a great solution. It can be intimidating to agree to a fixed monthly payment, like with a loan, when you aren’t sure what you’ll make in a month.
A merchant cash advance (MCA) allows you to pay based on what you earn.
Another advantage is that an MCA won’t appear on your credit report. So if you are planning for asking for a loan for something else in the near future, the MCA won’t be there.
How a Business Line of Credit Works
A business line of credit is also called revolving debt. You can think of this as a credit card. The financial institution sets a credit limit. You can use the money on your credit line as often as you want to and then you repay the amount you use.
Similar to a credit card, there will be a minimum payment you must repay every month, which will vary depending on your interest rate and the amount of the credit you’ve used.
You can continue to use and repay the amount on your credit line for as long as you keep the credit line open. The interest rates often change over time, meaning they are variable. You pay interest on the amount you actually borrow.
If you don’t use any money, you don’t pay any interest. This type of financing is usually a short-term financing option. They usually last for a year or less.
A business line of credit is a flexible option that is great when your needs fluctuate. So, a company with seasonal needs for financing may find that a business line of credit is a solid option for them. If a business owner needs to access funds repeatedly over time, a business line of credit is a convenient way to handle that. The borrower can use the amount of financing they need, pay it off, and repeat.
What Type of Financing Is Best For You?
How much do you need to borrow, and for how long? What are your loan term and short term financial goals for your business? The best option for your finances will be the one that best balances out affordability, you are paying less in interest and fees, and accessibility, so you are getting the money you need to successfully run and grow your business.