I’ve spent the past 15 months paying off over $30,000 of consumer debt. My wife and I are relieved that we’re no longer shackled to nearly $2,000/month payments anymore. Needless to say, when I hear the word debt, I don’t feel warm and giddy inside.
There is a lot of stigma around debt in today’s society, which should come as no surprise. Household debt in America has ballooned to over $14.2 trillion, nearly $93,000 per household.
Most of that is consumer debt, aka buying things we don’t need with money we don’t have.
However, debt is a tool and it’s one that has kept our economy going for hundreds of years. Knives are dangerous but when welded in a safe and responsible manner they can become quite effective. (Have you ever tried cutting a mango without a knife?)
Like knives, debt should be approached carefully. Setting aside my own personal qualms, I’ve set out to answer an important question: Is debt financing ever a good idea for freelancers, sole proprietors, and small business owners?
In this article, we’ll explore what exactly debt is, the difference between good and bad debt, and what to consider as a business operator.
What is debt?
When we think of debt, we often think of the horror stories of paying off student loans or getting slapped with preposterous credit card interest rates. Debt doesn’t have a good wrap around these parts.
But in the business sector, debt is a tool. Think about it for a second, would you have been able to afford college tuition at 18 years old without debt? Unless your parents have wads of cash doubling as toilet paper, probably not.
Debt opens opportunities not available to us with the capital we currently have on hand. Let’s do some quick math for a second. Let’s say your business has an extra $50,000 in the bank. You decide to invest the $50,000 in a rare car that’ll appreciate within a year. After a year, you sell the car for $55,000, a $5,000 profit. Not too bad.
Now, what if you took that $50,000 and used it as down payments for 10 of these cars and secured $450,000 of car loans. In a year, you sell each car for $55,000 but now have earned $50,000 of profit (minus whatever interest is generated from the car loans).
In this scenario (which I sole from How Money Works), debt gives you extra leverage to multiply your gains. Pretty cool, right?
Now, this is an entirely hypothetical situation. In real life, taking on debt is betting “on your future ability to pay back the loan,” according to Investopedia. And in business, nothing is ever certain.
Which brings us to the focus of this article: what do you need to know as a small business owner to make smart decisions around debt?
First, let’s take a look at the different types of debt available and the pros and cons of each.
Debt options for small business owners
There’s a reason we’re talking about debt financing and not equity financing: after paying off your debt, your relationship with your financier ends. They won’t own any bit of your business nor will they ever have to give you their blessing on major business decisions.
For most small business owners, debt financing is a much more realistic opportunity to equity financing. You probably service a small market and aren’t in need of $200,000 for 10 to 50% of your company.
Instead, all you might need is some start up funds to pay for equipment, enroll in courses, or even cash to tide you over while you bring on new clients.
Here are some different debt financing options available to you.
Friends and Family
Let’s get the most awkward option out of the way. You might be all gungho about frozen yogurt business with your friends and family cheering you on (from the outside) but whether they want to put their money behind your “dream” is another story.
If they do, great. Just be sure to button up a few things first. One, and this should be obvious, get everything in writing. Make sure you have all the terms laid out — repayment terms, late fees, length of the loan, etc.
Regarding interest rates, no matter how much Grandma insists on giving the money to you for free, to avoid paying a gift tax make sure you set a minimum interest rate per the IRS recommendations.
If everything works out and you’re able to pay back the loan plus interest, then you’re one of the lucky ones. If things don’t work out with your frozen yogurt business and Grandma now can’t afford the pool-side deluxe package at Oakwood Living, well things might get a little sour.
The pros of family and friend lending are straight forward:
- Below market rates
- No credit checks required
- Simple and fast to secure
- If things don’t work out, you’re going to upset some close people in your life
Besides asking grandma, a more traditional route to acquiring debt financing is directly from the trusty old internet. Now, lending criteria have become a bit more strict in recent years and chances are you’ll need to have good personal credit and collateral if your business is still new.
However, this option is much more feasible than traditional bank loans which often require 2 years of business operation. If you’re just getting started, this is obviously not ideal.
A quick Google search will reveal a plethora of options. Some might require a business lein, minimum credit score, and possibly proof of revenue. Do your research and look for low rates and offers without prepayment penalties.
Micro-loans through SBA
The U.S. Small Business Administration (SBA) offers a few flavors of small business loans. First up is a 7(a) loan which is the most common SBA loan. A 7(a) loan is typically used for:
- Acquiring short and long-term working capital
- Refinancing current business debt
- Purchasing furniture, fixtures, and supplies
It would take a book to cover all the types of businesses eligible for a 7(a) loan so it’s easier if I just share their list of ineligible businesses instead.
Next, are 504 loans which I won’t cover but leave for you a link to the literature. 504 loans don’t generally apply for new businesses. Instead, the SBA looks for businesses, “having qualified management expertise, a feasible business plan, good character and the ability to repay the loan.”
Finally, we arrive to the Micro-loan. According to the SBA website, “the average micro-loan is about $13,000.” Each micro-loan is administered through an intermediary lender who have their own set of lending and credit requirements.
Nevertheless, micro-loans are smaller loans used to enhance or grow your business with:
- Working capital
The SBA website is a great place to read up on all your options.
Now that we’ve covered most of your debt financing options, let’s close with the obvious: just because you can take a loan out for $20,000 (for example) doesn’t mean you should.
Have a clear idea of your realistic monthly income and expenses. If you’ve been in business for a few months and know that a $250 monthly surplus is achievable, calculate a loan with repayment terms that’ll comfortably fit into that margin.
Finally, I’ll leave you with some parting wisdom that I learned the hard way, never use debt to cover up other debt. It never fixes the problem.