Find out when it makes sense to apply for short-term financing.
Are you thinking about getting a small business loan?
There are so many financing options small business owners can consider!
Even with all the business loan options, term loans are among the most popular financing methods.
These types of loans come with different terms, which are the amount of time business owners have to pay them back. Short-term loans are a good option for some purposes, while longer-term loans are better for others.
This article will explain the differences between short- and long-term loans so you can figure out whether a short-term loan is the right option for you.
Short-term loans: The basics
Term loans provide you with a lump sum of cash that you pay back over a period of time, known as the term. A short-term business loan has a shorter term, meaning a faster repayment period than a long-term loan. The payback periods for short-term loans can vary, but itâs typically less than one year.
This type of financing lets you get access to cash relatively quickly. And even though short-term loans tend to come with higher interest rates than longer-term loans, the overall interest paid is relatively small because the money is paid back quickly.
Short-term loans can help cover cash flow issues and pay for unexpected business emergencies such as a need to replenish inventory, hire temporary workers to cover a busy period, provide working capital, or pay bills. They can also allow your business to take advantage of opportunities, such as launching a seasonal marketing campaign or taking advantage of a discount on supplies or equipment.
In short, these loans are better for covering smaller, more urgent capital needs rather than bigger, longer-term ones. Loan amounts are relatively small, providing enough money to deal with limited, immediate issues.
Certain kinds of short-term loans can only be used for specific purposes, such as purchasing equipment. These restrictions do not apply to all short-term loans, which means you should be able to find a financing option that meets your business needs.
You can apply for short-term loans from traditional banks, credit unions, and other brick-and-mortar financial institutions, along with online and alternative lenders. Loans partially guaranteed by the U.S. Small Business Administration (SBA) are available through SBA-approved lenders.
SBA loans and bank loans come with relatively low interest rates, but business owners must have good personal credit scores to qualify for them, and their companies must be in operation for a few years and have solid cash flow, annual revenue, and sales projections. (Startups and relatively new businesses typically donât qualify.)
Financing from online lenders usually comes with higher interest rates, but loan eligibility is easier. Funding can be fast. Once approved, you could get loan money deposited into your business bank account in one business day.
Very small term loans, known as microloans, are available through community-based organizations and the SBA. This financing is usually reserved for women and other minorities and businesses in disadvantaged communities.
Another popular type of short-term financing is a business line of credit. It works like a credit line youâd take out on your home. The lender provides you with access to funds, and you borrow against them as needed. You only pay back the money when you use it, and the interest rates on lines of credit are relatively favorable.
Long-term loans: The basics
Long-term loans are similar to short-term ones, and you can get access to this type of financing through the same types of providers. The critical difference is that you have more time to pay off the loan, often several years or even decades. Mortgages used to purchase business property are an example of a loan with terms as long as 15 or 30 years.
Although short-term loans typically have higher interest rates, business owners who get long-term loans usually pay more in interest. Even though the annual percentage rate (APR) is lower, the longer term and higher number of monthly payments mean you pay more interest on the money you borrow.
Qualifying for a long-term loan can be challenging because the lender takes on greater risk over a long period. The application and approval process is typically an extended one, especially through banks and other traditional lenders and for SBA loans. Your loan provider will want to make sure that if they lend money to you, you can repay it. Theyâll likely check out your credit history and review your assets as part of the loan application process. Theyâll also require you to submit bank statements, tax returns, and other financial records to prove your business is sound. Youâll also have to provide the lender with a current business plan that explains how you plan to use the money, how it will benefit the business, and how you plan to pay it back.
Long-term business loans are best for people who want to make significant investments in their businesses over time, for instance, to expand or buy real estate, expensive equipment, or a competitorâs business.
Short-term loans: When to use them
Short-term loans are relatively easy to qualify for and quicker to finalize than long-term business financing. This makes them ideal if youâre squeezed for cash because of an unexpected emergency and need funds quickly. Theyâre also suitable for taking advantage of limited-time business opportunities. Short-term loans can pay for issues or opportunities that will be resolved in a couple of months.
Typically, short-term loans require you to provide less documentation than long-term ones. The application and approval process can be faster and less stressful in many situations. Short-term loans have higher interest rates and typically come in lower amounts than long-term loans, making them less of a risk for the lender.
Also, bad credit does not preclude business owners from getting approved for short-term financing, especially if they apply through online and alternative loan companies. Short-term loans through these providers are a good option for those who have been in business for a short period, are dealing with credit problems, or are not eligible for traditional term loans.
If you apply through an online or alternative lender, double-check the interest rates, repayment terms, origination fees, prepayment penalties, and the reputation of the loan company. Make sure youâre getting a fair deal from a reputable provider. Also, be aware that if youâre accessing financing for a financial emergency and miss a payment, it could cause significant harm to your credit score. This could do irreparable harm to your company.
Here are some common scenarios where short-term financing is a sensible funding option.
Limited time operational costs
If you need seasonal (holiday or summer) support to purchase inventory to cover a rush period or buy a piece of equipment for a unique project, a short-term loan is a sensible financing option.
Unforeseen problems happen to the best-run small businesses. Weather emergencies, an equipment malfunction, unexpected tax bills, or inventory damage can occur at any time. While insurance may cover some of these expenses, itâs necessary to have cash to deal with these situations and get back on track. When an emergency arises, a short-term loan could help you manage through it.
Cash flow gaps
Almost every company has irregular periods of cash flow. For instance, several clients are late paying their bills, or a project takes longer than expected to complete. When you donât have the cash you need but can count on the money to come in soon, short-term financing could help you overcome the hurdle while continuing to run your business smoothly.
Sometimes businesses have a chance to earn additional income fast through a unique business opportunity. Perhaps thereâs a chance to secure provisional patent protection for a new idea or invention or fulfill pent-up market demand. In situations like these, entrepreneurs finance these upfront costs through short-term loans.
Short-term small business loans: The bottom line
Business owners with limited-term cash needs often turn to short-term loans to handle them. They can be better than taking money out of payroll or using a high-interest business credit card. Put simply, if you know youâll quickly recover or benefit from the financial event, a short-term loan could be a reasonable solution.
In the end, having a solid plan for paying back a short-term loan is critical. Your plan could include:
- Taking steps to ensure your cash flow during the repayment period is adequate to cover the loan payments.
- Setting aside enough cash to meet the monthly loan payments even if the projected revenue increases for the project youâre using the loan money to finance donât materialize.
- Identifying an alternate customer base if a new opportunity doesnât pay off with your current one.
- Coming up with a disaster plan before taking out short-term financing.
Proactively planning for anything that could happen while paying off your loan will help ensure taking out a short-term loan will benefit your business and not put it under.