Does a Short-Term Loan Ever Make Sense for Your Business?

We’ve all heard the horror stories: A small-business owner needs cash fast, so they take out a short-term loan. But soon, they’re stuck in an endless cycle of greedy lenders and crushing debt, and there’s no escape.

Sadly, this does happen -- and it happens way too often. People accept what seem like agreeable terms without realizing how their business’s cash flow or credit will be affected. That quick-fix payday loan can easily turn into a constant and unsustainable burden before you know it.

But that doesn’t mean all short-term loans will bankrupt you. If you’re a cautious and diligent borrower, a short-term loan could be just what you need to push your small business in the right direction.

Related: Why Your Business Needs Cash-Flow Yoga

Let’s explore more about what short-term small-business loans are, why they’re dangerous in the first place and when they actually do make sense for a small business.

1. What is a short-term loan?

As you might guess, a short-term loan is a smaller loan with shorter terms and faster time-to-funding than other loans.

They’re generally very versatile, as far as loan products go. Some types of loans can only be used for certain purposes, like financing equipment or purchasing property, but short-term loans don’t usually come with those kinds of restrictions. The most common uses are a need for more working capital, taking advantage of unexpected business opportunities or covering for damages in emergency situations.

Short-term loans are typically smaller than longer-term loans, but their term lengths are short -- often between three and 18 months -- and they’re quickly attainable. Whereas you might wait months for approval of a Small Business Administration (SBA) 7(a) loan, you’d only need a few days, if that, for plenty of short-term loans.

In exchange for these major plusses, you’ll nearly always pay a short-term loan back in daily installments, with a high-interest rate -- and there’s the rub.

2. Short-term loan, long-term danger

There are two main pitfalls with short-term loans -- their prices and their payment schedules. If you understand how they work, then you’ll be able to steer clear of the problems you might have fallen prey to.

First, short-term loans are just dang expensive. There’s no way around it. Fast cash is pricey cash -- and that’s a sustainable model for lenders, because people will always need money unexpectedly quickly.

Say you take out a $100,000 loan for one year with a factor rate of 1.18. Short-term lenders often put their fees in terms of factor rates, but you can see it as an interest rate, too. In this case, you’d pay back a total of $118,000 by the end of the year. If you’re making the standard daily payments, with 22 payment days in the average month, you can expect to have 264 payments of $446.96 each. Your short-term loan’s actual APR, in that case, would be 33.98 percent.

Not quite chump change. In fact, you could find medium-term loans with half that APR (if you’re an established borrower) and SBA loans one-tenth as expensive (which are difficult and slow to qualify for). Although your terms might sound fair, you have to remember that it’s all relative.

Second, there’s that pesky daily payment schedule to hold fast to. If you own a restaurant or manage a retail store, then you’ll probably have a daily influx of cash you can put towards those loan payments. But if your business relies on fewer or sporadic payments, then you might have some trouble with such a regular schedule. A daily payment could easily cut into your cash flow flexibility and restrain your options -- which might’ve been the reason you looked for a loan in the first place.

Related: The State of Small-Business Lending: A Return to Normal?

3. When does a short-term loan make sense?

You know what a short-term loan is, and how it can trap you if you’re unprepared. Think deeply about your business, spending habits and what you’ll need that loan for. Weigh the pros and cons -- perform a cost-benefit analysis -- and make sure you know if that particular loan will help or hurt you grow your business.

That said, here are some general points to think about.

• Revenue-generating: Are you pursuing a revenue-generating opportunity? If you want a short-term loan so you can fill a big order or grab hold of a great deal, then your return on investment (ROI) should be worth those interest payments. On the other hand, if you’re looking into a short-term loan so you can make payroll, you’re not in an ideal situation. That interest will be costly no matter what -- but it’ll hit you even harder if you’re not making anything extra to compensate.

• Cash flow: As we mentioned, daily loan payments can cut into your cash flow quicker than you think. If your business can sustain that debt schedule, then you’ll be alright. But if paying so often will restrict your options or even prove impossible for your model, then a short-term loan isn’t for you. If you only have a few clients, gain revenue infrequently, or have a lot of daily expenses, then consider looking elsewhere.

• Early payback: Taking out a short-term loan and knowing you can pay it off early is much less risky. Early payment for short-term loans can be a complicated topic, but the main issue to avoid? Getting stuck in a cycle of short-term loans being used to repay other short-term loans. If you’re going to go down the early payment route, just understand that, first, your interest likely won’t be forgiven, and second, if you’re refinancing that loan, then don’t do so with another short-term loan

• Emergencies: A storm breaks down your equipment. An employee gets sick. Or maybe your inventory fell off the back of a truck. Whatever the emergency, sometimes a short-term loan feels like the only option you’ve got. Be sure -- 100 percent positive, not a doubt in the world -- of how you’re going to pay that loan back, if you take one out. Don’t shrug and leave it to chance -- that’s how businesses get bankrupt.

Alternatively, prepare yourself for the eventuality of an unpredictable accident and take out a line of credit for your business in advance. You can pull from that line whenever you need, and will only have to pay on what you spend.

Related: 4 Things You Should Know About Business Credit Cards