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What’s the difference between short-term and long-term loans?
Both types of loans work in essentially the same way. You’ll apply for funding, the financial institution will look over your company’s creditworthiness, and they’ll offer a particular sum at a particular interest rate. You’ll repay the loan, plus interest, making regular payments.
However, the key difference between short-term and long-term loans is that short-term loans must be repaid quickly (typically under 18 months), while long-term loans can take years, even decades, to repay.
Great, you say. You want more time to repay the loan, so long-term loans are clearly best. Unfortunately, it’s not that simple. The repayment period isn’t the only difference between the two types of loans, and there are other important questions you’ll need to answer.
How much money do I need?
Small businesses borrow money for any number of reasons, and the loan amount will vary wildly based on your company’s reason in particular. After all, a trucking company looking to replace the tires on its fleet of vehicles isn’t paying anywhere near as much as a software company looking to buy an office building.
Remember, when a traditional bank or online lender is deciding whether to loan your company money, what they’re really considering is how likely it is that your company will be able to repay that loan with interest. They’re thinking about how likely is it that your company will earn them money. That decision is, in effect, a bet on a borrower.
A long-term loan typically will have a larger loan amount than a short-term loan. That makes sense for both lenders and borrowers. For lenders, it doesn’t make sense to give out many multi-million-dollar short-term loans because it isn’t very likely that the business will be able to repay that loan. Similarly, they don’t want to give out a $5,000 loan with a ten-year repayment term. That’d mean placing a tiny bet, and the best-case scenario may only earn them a few hundred dollars in interest.
So think about why you’re seeking out this new business loan. How big does the loan need to be to fulfill the purpose you’ve got in mind? If the loan is considerably large, you may want to consider a long-term loan.
In short: If you need a lot of money, you might want to consider long-term loans. If you only need a bit, a short-term loan might be more logical.
How’s my business credit?
Look at your company’s credit score. How’s it looking? If you’ve got bad credit, you may want to consider looking more at short-term loans than long-term loans. There are a few reasons that they’re likely to be a better fit.
If your company’s got low credit, you’re going to receive a higher interest rate on your loan. That’s the lender protecting its bet. With that being the case, think about how much more you’ll pay in interest over five or ten years vs. six months. When interest rates are high, it’s better to carry that interest for as short a time as you possibly can. A short-term loan means that you’ll only need to carry that high interest rate for a few months.
On top of that, if your business credit is strong, you’re going to receive favorable terms on long-term debt. That can be a massive boon if you’re looking to finance a major, long-term investment like a new space or additional retail location.
Many business lenders, and traditional banks in particular, require very strong credit for long-term loans. So if your business credit score is not as high as it could be, there’s a strong chance you’ll be unable to acquire a long-term loan in the first place. On the other hand, a recent Statista report shows that alternative lenders approve about a quarter of all loan applications.
In short: if your credit is excellent, large long-term loans are likely to be less expensive. If your credit is poor, short-term loans are likely your best option, if not your only option.
Will I be able to afford payments?
Once you start to pay back your loan you’ll need to determine whether your company can afford the payments. Long-term business loans are normally repaid using monthly payments. Short-term loans are sometimes repaid with monthly payments but can also sometimes be repaid with weekly or even daily payments.
How’s your cash flow? Would daily payments cause a crippling shortage in working capital? Or would it be better for your company to make larger monthly payments instead?
On top of that, think about how long you’re going to be carrying this new debt. Business owners sometimes look at the way things are going right now and assume that that situation will stay the same in the future. But what if your business is seasonal? Can you afford to make monthly payments in the busy season and the slow season? Are you operating in a volatile industry? If you’ve got long-term debt and can’t predict where your industry will be in two years, that can be a concern.
In short: Longer-term financing usually means monthly payments, while shorter-term financing might require more frequent payments. Also, think about how long you’re willing to carry debt.
Do I have any available collateral?
Because long-term small business loans are often so big, lenders often require that borrowers put up collateral – an asset that can be used to protect the lender from losing money. Real estate, vehicles, and inventory are sometimes held as collateral. If the borrower is for some reason unable to make payments, the lender can simply take possession of the collateral and sell it.
If you’ve got no valuable assets that a lender would consider using as collateral, you may not be able to provide the sort of security that’s required to get substantial long-term financing. That would make a short-term loan a better option by default. On the other hand, if your company uses a vehicle, you own real estate, or if you’ve got a large amount of inventory on hand, you may consider a long-term loan.
In short: Long-term loans sometimes require valuable assets as collateral.
When do I need the money?
Because of the increased risk that comes with a long-term loan, lenders take a long time to go through the approval process. The application process can also be arduous. Potential lenders will want to see your business plan, years’ worth of carefully-accounted financial records, your personal credit score, and more. And even then they can take a considerably long time to decide whether to lend to any given company.
Short-term lenders are much faster to acquire for several reasons. First, it’s not just big banks and credit unions offering them. There are also many alternative lenders online who can offer short-term financing to businesses in need. Because the loans are not as large as they are for long-term borrowing, alternative lenders are also able to offer loans to those with poor credit and short business history.
And it can be fast. Many short-term lenders can offer borrowers a lump sum as soon as 24 hours after the application is submitted.
In short: If you need cash quickly, a small short-term loan is likely a better option than a long-term loan, particularly if you’re not working with alternative lenders online.
Are There Other Options?
Finally, remember that short and long-term loans are not the only type of financing out there for small business owners looking to infuse their companies with cash.
SBA loans are comprised of several forms of financing backed by the United States Small Business Administration. While these can take the form of long- and short-term loans, there are other options as well. Because the US Government guarantees these loans, they’re often offered with interest rates, but have more stringent credit eligibility.
Equipment financing are loans taken out with the specific intent to buy, upgrade, renovate, or replace equipment. Whatever amount of money a company receives in an equipment loan must only go to that equipment purchase, rental, lease, or upgrade. The lender then holds the new or improved equipment as collateral, minimizing financial risk.
Business lines of credit are a form of lending in which a financial institution will allow a business to borrow up to a certain credit limit and only make payments on the money that’s borrowed under and up to that limit. They work much like credit cards, but are withdrawable in cash instead of being solely for making purchases.
Merchant cash advances (MCA) are not loans by definition. Instead, in an MCA, a company purchases a share of your company’s future credit and debit card sales. You pay the lender a percentage of each day’s credit and debit card totals up to a previously agreed-upon total. MCAs can move very quickly but are sometimes pricier than other options.
So which is best? Short-term or long-term loans?
As with many other choices when it comes to business financing, short vs. long-term loans really depend on the specifics of your company. If you’re looking for larger amounts of money with lower interest rates because of your company’s strong credit, longer-term loans might be the way to go. If you’re looking for a smaller amount to fund a specific project, you could save money with a short-term loan. Take the time to consider why you’re searching for funding, its purpose, and your financial outlook before you begin looking over your financing options.