Advantages and Disadvantages of Debt Financing
The biggest challenge for small businesses is access to capital. Debt financing can be a good option, but it’s essential to understand the pros and cons of borrowing money.
Borrowing money from a lender or bank is called debt financing. The person borrowing the money has to pay back interest, which means they have incurred debt.
For small businesses, debt can be a cost-effective option for companies that need funds. Debt helps by providing the company with inventory, employees, property, and equipment they may not have had otherwise.
Advantages of Debt Financing
You won’t give up business ownership.
Debt financing is one of the best methods for obtaining capital because you will not be giving up ownership of your company. On the other hand, if you give shares of stock in exchange for funding, outside parties may influence you regarding the future of your business.
There are tax deductions.
The advantage of debt financing is that it can provide tax deductions. The principal and interest payment on this type of loan may be deducted from the business income taxes as a business expense.
Always consult a tax professional or financial planner to help with your taxes.
Low-interest rates are available.
An SBA loan is an excellent option if you need money to grow your business, but the interest rates are too high on other loans and credit cards. The interest rate will be lower than what you would get from borrowing elsewhere. SBA loans are outstanding for low-cost financing.
You’ll establish and build business credit.
One of the reasons small businesses fail is their lack of working capital.
When you build your small business’ credit history and reputation with lenders by paying back loans on time or having good payment records in general, then a lender may give more favorable terms when providing future financing options.
Debt can fuel growth.
Long-term debt can be used to purchase inventory or equipment, hire new workers and increase marketing. Taking out a low-interest loan for the long term will give your company the working capital needed to keep running smoothly year-round.
This is important because it allows you to make additional profits without being cash-strapped.
Debt financing can save money.
One of the significant advantages of debt financing is that it helps you pay off high-cost credit cards, lines of credit, and cash advances. This can make your monthly payments hundreds or even thousands lower. Not only does this give you more money for day-to-day operations, but it also reduces how much interest your loan costs.
Long-term debt can prevent reliance on expensive debt.
Some lenders will pressure businesses into taking out short-term cash advances, but this strategy can trap a borrower in an endless cycle of debt. Instead, look to get an SBA loan with low-interest rates and extended terms so that small business owners are not forced back onto the same lending traps.
Disadvantages of Debt Financing
You must repay the lender.
Lenders are strict. They expect to be paid back if you borrow money from them even if your business goes under or can’t make payments. They require guarantees and the sale of assets to recover any debt owed.
To be successful, small business owners need a reliable source of funding. Sometimes the best option is debt financing, but predatory lenders exist, and they have advanced techniques for luring unsuspecting people into bad deals that will not work out well.
It impacts your credit rating.
If you’re applying for a loan, knowing if the credit check will affect your score is essential. Ask before taking out any loans.
You’ll need collateral.
Collateral is one of the 5 Cs in lending. Collateral reduces the risk for a lender and provides an additional form of security, which is often seen as unfavorable by some borrowers.
Final Thoughts on Debt Financing
Look for lenders who will give you a lower interest rate and longer repayment terms so that your business can grow.