It’s common for new businesses to borrow money to open their doors. Since they have little to no history to show their financial viability, many borrow using credit cards or other revolving or short-term debt.
Although these options can help the business get up and running, high interest rates can ultimately cause strain and tie up much-needed cash flow. Instead of being able to invest earnings back into the business, owners are stuck paying interest on the debt. Often, interest payments are so large that the business becomes mired. With revolving debt especially, each month the balance is not paid off means the total amount due continues to grow.
Fortunately, there is a solution. Refinancing business debt – paying back with a lower-interest loan – can relieve the stress and financial strain related to mounting interest charges.
- What is refinancing?
- When to Refinance Business Debt
- Types of Debt to Refinance
- When It’s Not a Good Idea to Refinance
- How to Refinance Debt
What is refinancing?
Generally, refinancing refers to using a longer-term loan option to pay back high-interest debt. It is also used to pay off debt from short-term loans such as merchant cash advances (MCAs) or revolving debt, such as credit cards and lines of credit.
Related Article: Should you get a merchant cash advance?
Many businesses use a term loan to refinance their debt. Term loans are structured with a set interest rate for the loan’s duration. Unlike MCAs and lines of credit, business makes regular payments that are always the same amount. In addition, term loans have lower interest rates and APRs than short-term loan options, freeing up cash for everyday use and allowing the business to grow.
When to Refinance Business Debt
Before refinancing, it’s important to ensure the new loan terms will ultimately save the business money.
Aside from the lump sum that now represents the original loan plus all interest, it’s important to research the fees associated with the new loan. These can include service fees, application fees, appraisal fees and origination fees. It’s also important to note whether there are fees associated with paying off the loan early, and the penalty amounts for missed or late payments.
Types of Debt to Refinance
You can refinance many kinds of debt. Some of the most common are short-term loans, such as merchant cash advances, lines of credit, and credit card debt. However, many businesses also refinance other term loans if they can qualify for a better rate and to extend the loan duration.
Merchant Cash Advances
Merchant cash advances give the borrower a lump sum upfront, which is then paid back on a daily basis by deducting a percentage of total credit card sales. Although MCAs can be helpful for businesses that experience seasonal slumps, they’re structured using a factor rate of 1.1 to 1.5 – meaning the borrower ultimately ends up paying up to 1.5 times the amount of the loan in fees, depending on how long it takes to pay back. This can equal out to a 50% APR.
Lines of credit and credit cards are both examples of revolving debt. Revolving debt allows the borrower to use part or all of their total credit for purchases and allows an interest-free grace period to pay it back – typically one month. However, if you cannot back the amount within the grace period, you’ll incur interest charges. For every month that the balance is not repaid, interest is charged on both the principal and any additional interest from the previous month. This can quickly add up to a large sum.
Existing Term Loans
Term loans are another type of debt that businesses choose to refinance. Although it may seem strange at first to use one term loan to pay off another term loan, there are many reasons to do so.
For example, a business may have only qualified for a high-interest term loan when they first opened, and now have the financial history to show they are qualified for a lower-interest loan. Alternatively, their first loan may have been with a lender that used predatory practices. Another possibility is that the business now has a high enough income to apply for a loan that will not only refinance their existing debt at a better rate, but will also give them some additional working capital for improvements or growth.
In many cases, businesses will choose a term loan to refinance existing debt to extend the amount of time required before total repayment, therefore lowering their payments.
When It’s Not a Good Idea to Refinance
Although refinancing is a great resource for many businesses trying to become more financially stable, it is not always the best option. If, after researching the new loan, the fees and associated costs don’t show an advantage in refinancing, it’s better to simply pay off the debt before taking out a new loan. If the company has a poor credit score or a short or incomplete financial history, interest rates may be too high to qualify for a better rate. Alternatively, if the new term loan requires regular payments that are so high that they’ll tie up a large portion of the business’ operating capital, taking out the loan may lead to a worse situation due to late payments that will ultimately affect the company’s credit score.
Additionally, not all term loans are the same. When choosing a lender, it’s important to thoroughly research their interest rates and fees to ensure it’s cost-effective to refinance. Interest rates on term loans can range from 6 percent to more than 80 percent, depending on the lender. The business’ and business owners’ financial history, credit score, and revenue can all affect interest rates. When coupled with hidden fees, refinancing may cost the business more than it saves.
How to Refinance Debt
Refinancing business debt requires the same records and information as applying for a loan for any other reason. Most lenders require the business to have been open for at least two years, plus submit financial records and bank statements. If you’re considering a specific lender, check its website for a list of requirements or documents you’ll need during the application process. Preparing the necessary documents before applying can save you time and make the process easier.
Related Article: Beginner’s Guide to Profit and Loss Statements.
Many lenders require a minimum credit score, and a minimum amount of yearly profit. Although there are loans and refinancing options for businesses that cannot supply this information, they can be incredibly expensive. In fact, such loans sometimes cost more than 100 percent of the total loan amount. Be sure to consider all aspects of the new financing deal before committing.
For businesses seeking a way to break the debt cycle and help their business grow, refinancing is a practical option. By lowering monthly payments and reducing interest payments, a business will be able to keep more of its revenue. In turn, you can reinvest in daily operations and fund improvements.