The Pros and Cons of Short-Term Loans for Small Businesses

February 6, 2024

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Short-term loans and alternative financing can be valuable financing options for small businesses needing quick access to cash to cover urgent expenses or maintain cash flow. However, these loans also have some drawbacks that entrepreneurs should consider before taking one out. This article will explore the pros and cons of short-term loans for small businesses.

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What is Short-Term Financing?

There are several short-term financing options available for small businesses. Some common examples include:

  • Short-term loans: These types of loans typically have terms ranging from three to 18 months and provide a lump sum of money that needs to be repaid with interest over the specified term. They can be useful for covering temporary cash flow gaps, unexpected expenses, or funding short-term projects.

  • Business lines of credit: A business line of credit provides a flexible financing option where a business owner can draw funds up to a predetermined credit limit as needed. The interest is only charged on the amount drawn, and once the borrowed funds are repaid, the credit line is replenished. This is a suitable option for managing cash flow fluctuations, handling unexpected expenses, or financing ongoing operational needs.

  • Credit cards: Business credit cards can be used to cover short-term expenses and manage cash flow. They often come with rewards programs, cashback, or other perks that can benefit the business. However, using credit cards responsibly and paying off the balance in full each month is crucial to avoid high-interest charges.

Alternative Financing

  • Invoice factoring: This financing option involves selling outstanding invoices to a factoring company for immediate cash, typically at a discount. The factoring company then collects payments from the customers. Invoice factoring can help small businesses with cash flow issues due to slow-paying customers or those with seasonal fluctuations in revenue.

  • Merchant cash advances (MCAs): MCAs provide a lump sum of cash in exchange for a percentage of future revenue. While not a loan, this financing option can be used for short-term funding needs. In most cases, you’ll be eligible for MCAs if you can show some annual revenue as most funders need 3-4 months of business bank account statements to approve business financing..

Pros of Short-Term Loans

Quick Access to Cash

One of the main advantages of short-term loans, as well as alternative financing, is that they provide quick access to cash for small business owners. The application process is typically faster than bank loans or longer-term financing options, such as Small Business Administration (SBA) loans. Online lenders, in particular, can approve and fund short-term business loans within weeks. If you need even faster funding, look to an MCA. Those can often fund you the same business day.

Less Stringent Credit Requirements

MCAs can be an excellent option for small business owners with poor credit history or a limited credit score. Funders offering short-term financing are generally more lenient with credit requirements than banks, which can make it easier for businesses with bad credit to qualify for financing.

Flexible Use of Funds

Merchant cash advances can be used for various business needs, such as emergency expenses, working capital, or cash flow gaps. This flexibility allows small business owners to use the funds for immediate business purposes, making short-term loans a versatile financing option.

Cons of Short-Term Loans

Higher Interest Rates

One drawback of short-term financing is the fact that it may come with higher interest rates. This can result in increased overall costs for the borrower.

Limited Loan Amounts

Short-term financing generally offer smaller amounts than longer-term financing options. This means that small business owners may not be able to secure enough funding to cover all of their needs. Look for a reputable funder with good ratings and that can fund higher amounts. The LCF Group for example can fund up to $2M.

Is a Short-Term Loan Right for Your Business?

When considering a short-term loan or forms of alternative financing, small business owners should weigh the pros and cons carefully.

When considering whether short-term financing is the right choice for your small business, consider the following factors:

  1. Purpose of financing: Identify the specific purpose for which you need financing, such as covering cash flow gaps, funding short-term projects, purchasing inventory, or addressing unexpected expenses. Short-term financing is generally more suitable for temporary cash needs or funding immediate business opportunities.

  2. Cost: Short-term financing often comes with higher interest rates and fees than long-term loans. Evaluate the total cost of the financing option you’re considering, and ensure it aligns with your business’s financial situation and budget.

  3. Repayment ability: Assess your business’s cash flow and ability to repay the required funding. These may have more frequent payment schedules (such as daily, weekly or monthly payments) and shorter repayment periods. Ensure that your business can comfortably manage the repayments without causing undue financial stress.

  4. Credit history: Your personal and business credit scores can influence the type of financing options available to you. You might have access to more favorable loan terms and rates if you have a strong credit history. On the other hand, if your credit score is low, short-term financing options like invoice factoring or merchant cash advances might be more accessible.

  5. Speed of funding: If your business requires immediate access to funds, short-term financing options like business lines of credit, merchant cash advances, or online lenders can provide quicker funding than traditional bank loans. Consider the urgency of your financing needs when evaluating options.

  6. Flexibility: Short-term financing options like business lines of credit offer more flexibility than lump-sum fundings, allowing you to draw funds as needed and only pay interest on the amount borrowed. This could be a valuable feature if your business requires flexibility to manage cash flow fluctuations.

  7. Alternatives are available: Explore all financing options available, including long-term loans, grants, alternative lenders, or equity financing, and compare their terms, costs, and suitability for your business’s specific needs. Short-term financing might be more appropriate when other options are not viable or do not align with your business goals.

If you’re in need of a larger amount or longer repayment terms, you might want to consider alternative financing options, such as a business line of credit, SBA loans, or long-term business loans from banks. These options can offer lower interest rates and more favorable terms than short-term loans, but they may also require a more extensive application process and have stricter eligibility requirements.

Ultimately, the best financing option for your small business will depend on your unique needs and financial situation. Before taking out a short-term loan or any other type of financing, it’s essential to carefully assess your business’s cash flow, credit history, and funding requirements to ensure that you choose the most appropriate solution for your business.

*Repayment in this context describes the process of repurchasing a merchant cash advance. It does not describe the process of repaying a loan. MCAs are legally distinct from loan products.

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