The Merchant’s Guide to Short Term Loans
New businesses often have very little access to capital. Investors are difficult to come by. Bank and SBA loans are almost always out of the question. And your family and friends are only willing to give you so much money. Many a startup has been tempted to get a short term loan, which often have lax standards and are willing to wire the money fast.
But, given the difficulty of getting funding elsewhere, is the money too good to be true?
Sometimes, yes. Short term loans tend to come with exorbitant fees and rigid payback schedules. Many startups—and seasoned businesses—have been died untimely deaths due to improperly used short term loans. However, for the right business, a short term loan might be just what you need to keep your business chugging along until you’re able to either avoid loans completely, or refinance your loan with a cheaper option.
The trick is to know your business, and understand the lending model.
While there are exceptions, in general short term lenders are not terribly interested in working with you to ensure that your business is able to operate under the reduced profits. You’ll have to ensure that yourself.
Here’s everything you need to know before getting a short term loan.
Why Use a Short Term Loan?
Short term loans are generally used to fill gaps in your cash flow. For example, if the holidays are coming up, a merchant might accept a short term loan to buy extra inventory. Occasionally, they’re also used for larger projects like expanding to a second location or purchasing new equipment.
You’ll notice that in the scenarios above, the business just need a little extra money to expand or improve profit margins. In theory, the money should basically pay for itself once it’s put to use in growing the business.
The problem is, merchants accept these loans to cover everyday operating expenses instead. These loans are extremely short-term, which means if you accept one, you’re going to be repaying a lot of money really, really fast. If your business isn’t doing well covering its own expenses, adding an extremely expensive loan to the mix is going to be a significant hindrance in the long run. Please do not do this to your business.
Breakdown of a Short Term Loan:
If you’ve know anything about merchant cash advances, some of this information is going to sound mighty familiar to you. Merchant cash advance providers will often also offer short term loans as an alternative. While the two sources of capital are similar, they have some key differences.
A typical short term loan offer looks like this: you need $25K to buy some much needed equipment for your business. You find a funder that you think is trustworthy, and apply online. The funder offers you the capital that you need, with a one time buy rate of 1.28 (28% of the loan) for an 8 month term length. Additionally, there will be an origination fee of 3%, and an administration fee of $200.
To repay the loan, you’ll be making daily payments of $182. But you won’t even notice because the funder will take the payments right out of your bank account via ACH. If you accept, the money will be available in your bank account within two business days.
Now for what all that means.
Term length: The most obvious defining characteristic of a short term loan is that it’s short. We’re talking really short here. You’re looking at a term length between 3 and 18 months.
Factor rate: Short term loans do not have interest rates. Instead, they have something called a factor rate, also known as a buy rate or one time fixed fee. This number is generally written as a decimal point (1.28), but might also be written as a percentage (28%). In general, you’re going to get a factor rate somewhere between 1.15 and 1.4 on any given loan. To calculate how much money that adds up to, multiply the factor rate by the principal (the loan amount).
So, using our example above, $25,000 x 1.28 = $32,000. When you’ve repaid the whole loan off, you’ll have paid $32K total.
I cannot stress this enough: even if it’s written as a percentage, and even if the term length is one year, factor rates are not the same as interest rates. The difference is, factor rates are calculated once based on the original principal, but interest charges are calculated multiple times based on a depreciating principal. The same loan ($25K with a term length of 8 months) with an interest rate of 28% would ultimately cost you $27,696. That’s a difference of over $4,000 dollars.
Other fees: Small term loans often come with some sort of processing fee like an origination fee, closing fee, or administrative fee, which are intended to cover the cost of assessing and underwriting your loan application. These fees could be a percentage deducted from the principal, or simply a one-time fixed fee.
Another common fee you’ll run across is an NSF fee. Also known as an insufficient funds fee, this is a fee charged if you don’t have enough money in your account when the lender attempts to collect their daily payment.
Collateral: Don’t think that just because these loans are “unsecured” you can default on a loan and get away with it. Lenders usually ask you to sign a personal guarantee or they file a blanket lien, which means that if your business defaults on a loan, you’re personally responsible for repaying the remaining balance.
Repayment: Repayments are deducted straight out of your bank account via ACH. You do have to give the lender access to your checking account, so make sure you’re working with a trustworthy lender. These payments are almost always daily, but some lenders do offer a weekly option to qualified borrowers.
Repayment is the biggest way in which short term loans differ from a merchant cash advance. Unlike the latter, in which repayments fluctuate along with your cash flow, short term loans have fixed repayments.
Because your fee is only calculated one time, you cannot save money by paying off a short term loan early. However, many lenders are starting to offer a prepayment discount for merchants who do just that. I would recommend looking for a lender who offers that kind of discount.
The Bottom Line
See those two men sitting in the white featureless void of an image above? Those people are making sure that their business can handle a short term loan. Follow their example.
Be very careful when applying for this type of loan. As it turns out, fast money and lax qualifications lead to expensive consequences. Take the time to ensure that the extra money will be a boon, not a hindrance, to your business. Make a plan for how you’ll use the money, and execute that plan. And please, please don’t get the money just because you can.
If you’re interested in getting a short term loan, check out our comparison chart here.