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What is Debt Consolidation?
It is not uncommon for small business owners to have multiple forms of credit open. Whether it is a business line of credit, a small business loan, or some other type of loan that you may have stacked on another loan to launch a business or just keep it operating. At the time, you had valid reasons to borrow, but now that debt could be hurting your business.
This type of debt problem has grown exponentially with the economy struggling because of Covid-19. Many business owners took out a business loan or some other form of debt and started expanding their business right before the pandemic exploded. Others are currently dealing with the fallout and are struggling to deal with the various payments outstanding on their everyday operating debt.
Staying on top of multiple loan payments in one month can become mentally wearing, and pull your attention from your business. The interest rates and fees could now outweigh a business loan’s initial benefit. These factors could make you an excellent candidate for debt consolidation.
Before you decide to consolidate your debt, learn about the best uses for a debt consolidation loan, look at its benefits as they relate to your situation, and explore your options. Making an educated borrowing decision will set you up for long term success.
Is Debt Consolidation the Same as Business Loan Refinancing?
While you might have heard the terms used interchangeably, debt consolidation is not exactly the same as refinancing, although the outcomes can be very similar. Refinancing replaces an existing small business loan with a new business loan that has more desirable terms hopefully. It’s a one for one trade.
Debt consolidation groups together many loans into one new loan so there are no longer multiple payments. The borrower now only deals with one payment, and again the hope is that those payments have better terms combined, compared to when they were individual debt obligations.
In simple terms, the borrower is trying to lower their payments or at least make them easier to manage.
What are the advantages of consolidating your debt?
If you owe different lenders and have opened multiple loan products, there are several advantages to debt consolidation. Taking some time to explore your options and apply online could save you a lot of time and aggravation in the future. Before borrowing, however, it is wisest to know how the loan will help your business and how you intend to use any additional funds.
Easier to Track Payments
One of the first reasons to consider debt consolidation is to ease budgeting issues. Making multiple payments on different days and managing those lenders takes time away from your business. It could also cost you money in late fees and interest charges if you forget to pay something on time.
As well as late fees, many lenders charge fees such as monthly servicing fees, payment processing fees, and more. While ten dollars a month may not sound like much, ten dollars to five different lenders plus one missed payment fee could quickly become more than a hundred dollars. Those fees can quickly destroy your budget and raise your borrowing costs.
Even if you have set up auto-payments to make your life easier, you have to make sure that there is money in your checking account to cover them. With multiple lenders, you will need to monitor your checking account balances three or four days a month. It takes a mental toll and pulls your focus away from running and growing your company.
A consolidated debt repayment schedule can save you time and money. Many small business owners find that rolling all their debt into one loan product and payment takes a huge weight off their shoulders.
Get a Better Interest Rate
Newer business owners rarely receive the best rates on first time loans, regardless of their personal credit. Lacking much business history upon which to base a lending decision, lenders charge higher rates to better cover their risk. Also, newer borrowers may accept unfavorable terms just to access capital. But now, after several months or years in business, with a combination of borrowing history and experience, you will likely receive a better rate.
Even if some of your debt has a better rate than the consolidated rate, you have to think of the larger picture. A credit card or line of credit will have a variable interest rate, with a fluctuating payment. And the blended rate could be higher, overall than what you may be able to get today.
A blended rate takes the balances on all credit lines, loans, and credit cards, and multiplies them by their respective interest rates to come up with an overall interest rate. Also called a weighted average interest rate, it could surprise you. Even if you have a small loan at six percent, if you have two credit cards charged to their limits at 25%, consolidating them into one loan product with a 12% rate could produce cost savings overall.
If you needed cash in a hurry at one point you might have stacked loans. Loan stacking happens when you take out several loans to finance one project. For example, let us say you wanted to finance a restaurant expansion, and needed $60,000. One lender was only willing to extend $40,000 in credit so you had to take out another loan for the balance. That is loan stacking.
Debt consolidation is not loan stacking. With debt consolidation, you combine and replace all of your existing debt into one new business loan. While it can sometimes save you money on interest and fees, that is not always the case. Sometimes the only benefit of debt consolidation is the reduction in administrative work and more manageable payments.
Manage Cash Flow Better
With just one loan payment instead of many, budgeting becomes simpler. Depending on the payment plan you select, you may just have to budget for loan payments monthly, weekly, bi-weekly, or even daily. Some loan products – such as merchant cash advances – just take a percentage of your sales for repayment and you do not have to do a thing.
Money saved if you wind up paying less interest can be reinvested into your business. Or, if lowering your monthly payment is a top priority, you could trade off some cost savings for an extended payment term. Monthly payments of $2,000 on a $10,000 loan due over five months could become $1,000 if you extend the term to ten months.
Extending the repayment term could lead to paying more in interest. But if improving cash flow is a higher priority, especially during an economic downturn, the better business decision could be to extend repayment and lower monthly payments.
Keep Your Collateral
Another instance where it would make sense to pay more in fees to consolidate debt is if you could possibly default on an asset-secured loan. If you presented a greater risk profile to the lender, they may have required you to pledge a large capital asset to secure funding. As a result, the lender could have the right to seize a building, your home, or your business if you default.
Obviously, it is always preferable to pay more for capital if it prevents losing your home or an asset necessary to run your business. Debt consolidation which pays off the asset-backed loan could be your best move. Be aware that you have already missed or made late payments that have hit your credit report, a new business loan will cost you more.
Sometimes small business owners have to weigh several considerations when making the best debt consolidation decision for their business. The answer is not as simple as “save money in interest and fees,” and that is not always the best path to take.
What are the Disadvantages
1. One disadvantage of consolidating debt is locking yourself into a debt obligation that costs more than your current situation over the long run. Although you may lower your payments initially, if you extend the maturity dates you can end up paying more interest expenses over the life of the loan.
2. Another disadvantage is that the weight of debt gets somewhat lifted when you get a lower payment or less and more manageable payments and then you go out and spend more. The point of consolidating your debt is to manage your debt better, so budget your money moving forward and look at consolidation as a point where you change your spending habits for the better.
Preparing to Consolidate Your Debt
Taking the time to prepare your application and documentation before approaching a lender will save you time and aggravation. Chances are, you need capital quickly and want to improve your financial situation sooner rather than later. Submitting incomplete documentation slows the loan approval process and leads to unnecessary delays.
Pull together all information about your current business debts. This should include your most recent statements with outstanding balances, interest rates, due dates, and the lender’s contact information. If you have not already, plug all of this information into a blended interest rate calculator.
A blended interest rate calculator tells you how much you are paying for all your debt combined, and knowing this rate will help you compare loan offers. It can inform your decision between multiple loan offers, or help you determine if the loan you are offered saves you money in interest or fees.
While gathering documents related to current debt, check for prepayment penalties. A prepayment penalty in a loan contract means that even if you pay the loan off early, you will pay some of the future interest. This additional lump sum payment to the lender reimburses them for the profit they will lose out on when they do not receive all your future payments.
Even if you must pay a prepayment penalty, a debt consolidation business loan could still be worthwhile. You could still pay less overall, or rolling that loan into a debt consolidation loan could ease your cash flow situation. But you should factor the cost of prepayment penalties into your calculations.
Something else you will want to know before contacting lenders is your credit score. The major credit bureaus must provide you with one credit report yearly, free of charge. Knowing what is on it, and your overall score, will tell you where you will likely be able to obtain funding.
Once you have all this information in hand, you are ready to approach lenders about debt consolidation. Depending on your credit score, you will have several options.
Traditional Bank Loans for Debt Consolidation
Banks and traditional lenders will approve small business owners for debt consolidation loans if they qualify for funding. Traditional lenders rarely work with borrowers who have less than excellent credit scores. They also prefer that your business has been in operation for at least two years, and that you have low debt service ratios.
On average, it takes up to three months, for a bank to approve a loan. Expect to provide significant documentation with your application, such as bank statements, tax returns, business plans, financial statements, and more. If they require certified statements, you may have to pay an accountant to prepare them. If you cannot afford to wait for financing, a bank loan is not your best option. However, if you have time and can find a way to meet a bank’s requirements, banks usually offer the lowest interest rates and longer repayment terms than any other lender.
SBA Loans for Debt Consolidation
Small Business Administration loans exist to promote the success of small businesses in America. If you are approved for an SBA loan, the government guarantees a portion of it to the lender, which lowers their risk. Thus, banks will lend at a lower interest rate and to slightly-less qualified borrowers.
With the government guarantee, the lender does not demand as high of a credit score. There are, however, still fairly strict qualifications including time in business of two years and a credit score above 660. The approval process lasts just as long as a traditional bank loan, and there are restrictions on what you use the loan’s proceeds to fund.
It is important to note that traditional SBA loans are not the same as the Payment Protection Plan or PPP loans, or the EIDL disaster loans enacted through he CARES act. These are temporary programs that will likely run out at the end of 2020, but they have eased many requirements and even have portions of the money forgiven. Once those options are exhausted the SBA will still have great funding programs and they are really worth it as a debt consolidation option if you have the time and can meet the requirements.
Alternative Lender Loans for Debt Consolidation
Alternative lenders offer private business loans that have a quick approval process and can fund a loan within a few days. They are the quickest and easiest way to obtain capital. You can apply online and they have much fewer documentation requirements than a bank.
Alternative lenders will help businesses consolidate debt even if they have only been operating a few months or more. They lend to borrowers with credit scores as low as 500 with business loans bad credit. Instead of heavily weighting your credit score during the underwriting process – like a bank – they consider your minimum monthly revenues to be more important.
While minimums vary between lenders, most require monthly revenues of at least $8,000 for a business loan approval. Interest rates are both a reflection of risk and a lender’s profit. If you have a lower credit score, you represent more risk to the lender so you will pay more to access capital.
The typical range is between 5% to 45% at an alternative lender depending on the duration of funding. With an alternative lender, you could pay a factor rate instead of an interest rate. Expressed as a decimal, such as 1.0 or 1.45x, a factor rate is a flat fee. To calculate it, simply take the amount you are borrowing and multiply by the factor rate.
For a loan of $100,000 with a factor rate of 1.5x you would pay the lender $45,000 on top of the principal. Some business owners prefer this method because there are no surprises such as with a fluctuating interest rate or additional fees. You know from the day you borrow what you will pay for the funds.
Duration of the loans are from two months to three years, whereas a bank business loan ranges from 1 year to 7 years or more. Alternative or online business loans offer rates that can go as high as 45% or more depending on how long the funding is for whereas a bank is going to charge anywhere from 5% to 22% based on a yearly basis.
All lenders have different types of fees on the loan, both banks and online lenders. The point is to evaluate all lenders, all of the fees, where you can get an approval, and the overall savings you will receive wen you consolidate your debt.
Deciding on a Debt Consolidation Loan
If you have the time, it is always a good idea to compare lenders. When you’re looking at debt consolidation, it is rarely an emergency situation and you have time to sit down and compare offers.
Look at the different terms and rates and consider your borrowing priorities. Maybe choosing a higher interest rate in exchange for a lower monthly payment makes more sense for your cash flow situation. Or, you want a longer term because of cash flow uncertainties.
If you only applied with one lender, compare the factor rate that they are offering you to your current blended rate. Read the contract’s fine print and look for prepayment penalties, paperwork incurred costs, or missed payment fees.
Take your time to weigh all the factors when borrowing against your business needs and reasons for consolidating your debt. It is a decision you could have to live with for a few months or a year and you want to pick a great lending partner. It is always helpful to get the advice of an accountant or CPA with this type of financial decision.
What Happens Once the Debt Consolidation Loan is Approved
Generally the business loan you get will be given to you via your bank account and you will have to pay off the different debt obligations. There are times however that a lender will make the payments on your behalf, this will depend on the lender and the loan type. If you have to settle the debts and you fail to pay off your other loans with the funds, it could jeopardize your financial future. This entire financial process should be well thought out and you should have a concrete plan from beginning to end.
A business loan for debt consolidation could be the smartest move you make to support your company’s continued operations and growth. Not only will you improve your debt management and possible lower your payments, it will help you build your credit history and make borrowing easier and cheaper in the future. If you have been considering consolidating your debt, talk to a Shield Funding business loan expert today.