The Perils of Short-Term Business Loans

Funding your start-up is seldom easy. Your options are limited. Friends and family members normally can only invest a small amount. Bank loans can be hard to come by. Government programs can take months to navigate. Small business owners may consider alternative and short-term lenders when cash gets tight. However, before doing so, you need to understand what you are buying.

As example, let’s say that you are going to borrow $50,000. You only need the capital for one month and the small-business lender tells you it charges three percent. In most cases, this is three percent per month. In other words, if you borrow $50,000 for one month, you must repay $51,500 ($50,000 of principal plus $1,500 of interest).

If you need to extend for an additional month, it is another three percent. If you do that for a year (12 times), you would pay $18,000 in interest (12 times $1,500). However, $18,000 divided by $50,000 is 36 percent. Therefore, even if you only keep the loan for one month, you are paying an interest rate that is 36 percent per year. Of course, you’ll never hear one of these lenders say that they are charging you 36 percent. That rate doesn’t sound attractive. Nevertheless, that’s what it is. You wouldn’t dream of paying that interest rate for a home loan or a car loan. Most credit cards offer better rates.

Related: Cash Crunch: What's the Best Loan for Your Small Business?

This type of lending is very expensive. In short, almost any other loan you could get would cost you less. You could take a second mortgage on your home, refinance your automobile, apply for a new credit card or ask your Uncle John for a loan. Explore all of the other options before taking this type of loan. It’s probable that any other option would cost you less, probably much less.

Another option is to bring money into your business by taking on a partner -- an angel investor. Sell part of your business to an investor to get the money you need. The popular show Shark Tank shows people trying to do this each week. If you follow this route, there are many precautions you should take, but that’s another topic.

Suppose you have no other options. There are no viable investors. You don’t own a home. Your car loans are maxed out and credit card companies aren’t interested because your credit isn’t good. If you literally have no other options, short-term or alternative lending might make sense. The key question is how long will you need to borrow the money?

If you will need money for the long term and there is no other source of capital, our best advice is to close down your business. Essentially no legal enterprise can deliver a return of more than 36 percent in the end. If your business doesn’t deliver more than your cost of capital, you will eventually go out of business anyway. Facing that fact now will allow you to cut your losses.

Related: How to Save Your Business From Doom

On the other hand, if you truly need the money for only a short time, it may be that such a loan will make sense. For example, you owe your suppliers money. They are refusing to provide the material you need to work until they are paid. Customers owe you money for work you have previously done. What you are owed is enough to cover your obligations and you believe that you will receive payment in the near future. In this case, a short-term loan, even at a very high interest rate may make sense because it allows you to keep working.

Be cautious, there are many lenders that prey on small business people who have a dream, but are not financially sophisticated. In some cases, the rates are usury. Accepting such rates will cause you to dig a deeper hole in the long run. Nevertheless, there may be situations where these loans are appropriate.

Related: Applying for a Short Term Business Loan Online? These 4 Steps Can Protect Your Startup.