andresr/Getty Images: Illustration by Issiah Davis/Bankrate
Many small businesses can struggle with growth because they need access to capital. According to the 2022 Small Business Credit Survey, 42 percent of small businesses obtained funds that must be repaid in response to financial challenges.
Though it might seem risky, leveraging the right type of debt funding can be a cost-effective way to take risks and seize opportunities to buy inventory, hire employees and purchase equipment or real estate. Understanding the options, pros and cons of debt financing can help you choose the best solution for your business needs.
What is debt financing?
Debt financing is an agreement between you and a creditor. The creditor provides the funds you need for your business, and you agree to repay the creditor the amount borrowed, including interest, by a specific date in the future.
There are short-term and long-term debt funding options available. Which option is best for your business depends on how much funding you need, why you need the funds and how much time you need to repay the debt.
Types of debt financing
There are multiple types of business loan debt financing to choose from:
- Line of credit: Offers larger lump sum amounts you can draw on as needed, with interest accruing only for the drawn amount.
- SBA microloan: This program provides up to $50,000 in loans for minority businesses needing working capital and who can meet strict eligibility guidelines.
- Invoice factoring: Businesses can sell off unpaid customer invoices to invoice factoring companies for an immediate cash infusion of up to 90% of the invoices’ value.
- Merchant cash advance: Companies with significant debit or credit card sales can get a cash advance on future sales. This debt funding option is easy to qualify for but has high fees.
- Business credit card: Provides revolving credit for businesses with good credit but can have high interest costs if not paid in full each month. Often has perks, such as cash rewards or introductory APRs.
- Equipment financing: Provides funding for businesses needing large equipment, like semi trucks or contracting equipment.
- Commercial real estate loan: Provides funding for business real estate purchases with long-term repayment options.
- Term loan: Startups and established businesses needing to make a single large purchase may qualify for a term loan.
Subprime borrowers may have fewer options but can still get debt funding through bad credit business loans. Comparing options can help you get the most favorable terms if you find it difficult to get a business loan. Bankrate insight Applications for the most traditional types of debt financing — loans, lines of credit or cash advances — rose to 40 percent in 2022, increasing from 25 percent in 2021. The top reasons for applying for financing? To meet operating expenses, expand business, pursue new opportunities or acquire business assets.
Pros and cons of debt financing
| Pros | Cons |
|---|---|
| Debt financing allows businesses to maintain ownership and control over the company. | Repayment is a requirement, even if the company fails. |
| The principal and interest are typically tax deductible as a business expense. | Interest and fees can make debt financing costly, especially for new businesses or businesses with poor credit. |
| Repaying debt funding on time can help you establish and build or improve your business credit. | To get the best repayment terms, you need collateral, which the creditor can take if you default on the repayment terms. |
| It can be one of the more affordable debt solutions, especially if the business is well-established and has good credit. | Qualifications can vary, and some debt financing is more difficult to qualify for than others. |
Pros of debt financing
- The business retains ownership control
- Tax-deductible repayments
- Helps establish or build business credit
- Can be affordable for well-qualified applicants
Cons of debt financing
- Could negatively affect personal or business credit if you fail to repay
- Could be costly for businesses with poor credit
- Collateral is usually required for the best repayment terms
- May be challenging to qualify for
How to choose the right debt financing for your business
Choosing the right debt financing for your business is crucial for your company’s future success. Taking the right steps to get a business loan can improve your chances of qualifying for the amount you need with the best terms.
Answering the following questions can help you determine the best type of debt financing, making it easier to determine what small business lender will best fit your needs:
- Why do I need funding?
- How much capital do I need?
- What requirements do I need to qualify?
- How fast do I need debt funding?
- How much debt can I afford to take on, and what’s my budget for repayment?
The documents you need to secure a business loan will depend on the type of loan and lender you choose. Researching what you need before applying can make the application process easier, which means faster approval and funding.
Alternatives to debt financing
Although taking out a business loan is a common way to get funding, it’s not the only option. There are debt financing alternatives you may want to consider:
- Small business grants
- Crowdfunding
- Equity financing
The bottom line
Some businesses determine debt financing as the best solution to grow their business. Before you decide which type of debt financing is right, consider how much funding you need and how you’ll repay it. There are short-term and long-term solutions that can meet most business needs. By researching and understanding your budget needs and goals, you can find the right debt funding option to help you turn a small investment into a significant business asset.
Frequently asked questions about debt financing
Some examples of debt financing include short-term and long-term loans, SBA loans and business credit cards or lines of credit. Equipment financing, invoice factoring, commercial real estate loans and merchant cash advances may be a good fit for businesses with specific debt funding needs.
Debt financing means borrowing money from a creditor and paying it back over time, with interest. Loans are a common type of debt funding, but there are other types, like credit cards, lines of credit and merchant cash advances.
The main benefit of debt financing is getting the working capital your business needs to grow. Most types of debt funding provide a lump sum, which companies can use to buy inventory, real estate or equipment, expand or hire employees. Businesses can also build or establish credit and relationships with banks and lenders, which can help them access funding options in the future.
