Loan Stacking, What it is and If It’s a Good Idea for You
There will come a time in your small business’s life cycle when you will need to borrow. Whether it is to expand, to take advantage of a new business opportunity, or to develop a new product, it is rare that existing cash flows will support making it to the next level.
Getting approval for that first business loan can seem like a huge hurdle, and when you are offered another loan shortly after taking out the first loan, it may be tempting to jump at it. Or, what if you have spent all the money from the first loan, but have not repaid it, but need more cash?
When you need more capital, but already have outstanding loans and lines of credit, many small business owners turn to loan stacking. But loan stacking can be quite risky, and not always a good idea for your business.
What is Loan Stacking?
When you take out a loan, and then another loan, and then maybe a line of credit, you are loan stacking. In this example, none of the loans are to re-finance or repay an existing loan, which is why it is considered stacking.
The issue that many lenders see with loan stacking is that you could just be going deeper and deeper into debt to rescue a failing business. With each loan or access to credit your odds of repaying them get worse.
How does Loan Stacking Happen?
Loan stacking happens when business owners need more capital but have not yet repaid an older loan or line of credit. Let us say that you put together a business plan and applied for a loan for $20,000. But the lender did not consider you a worthy credit risk and only approved you for $10,000. At that point, you might consider loan stacking.
If one lender gave you a short-term loan, you might approach another bank about opening a line of credit.
In other instances, someone approaches you about loan stacking. When you take out certain loans, the lender will file a UCC form with the office of the secretary of your state. This is a public record of your debt.
Unscrupulous lenders scour these records and will then approach you about taking out another loan. The pitch may be, “We saw you just took out a loan for $5,000. Could you use more capital?” The lenders tell you that you won’t need to go through an application or approval process; it is just that easy.
The reason is that they can make an educated guess as to your credit-worthiness when they know your first lender. They will be familiar with their underwriting process and, on that basis, judge you worth the risk. But never forget that paying for capital that you do not need only uses up resources that could go elsewhere.
What is a Subordinate, or Second Position, Loan?
Alternative lenders frequently take a subordinate position when lending to small businesses. A subordinate, or second position, loan is one that is second place to lay claim on your assets should you default. While traditional lenders are rarely willing to take a second place position, an alternative lender will.
If a loan is in second place, the lender gets what is left in the event of default. The first lien holder will liquidate all of the businesses assets and claim any personal assets that you may have pledged. Whatever is left is used to satisfy the second place lender’s claim.
The alternative lender will consider which bank gave you the money for the first place loan when making their lending decision. This is because they know their odds of recovering their money are better if a top-tier financial institution considered your business to be a good credit risk.
It is a riskier proposition to be in second place. To offset this risk, the subordinate lender will charge you higher fees.
Is Loan Stacking Legal?
Yes, it is legal, but it can violate the terms of one or all of your loan contracts. Often, the first lender will have a clause in their loan that states you cannot take out another loan without their approval. Or you cannot take out any other loans, or any other loans you receive will be subordinate to their loan.
The second lender could also have clauses in their contract that states the same, at which point the two lenders would be in conflict with one another if you defaulted and they tried to seize your assets as repayment.
When lenders pull your credit report, they can see if you have any loans currently outstanding, as well as the amounts due on any lines of credit. There is often a 30-day lag between closing on a loan and when it hits our credit report. You could take out multiple loans during that time.
This is a terrible idea. Many loan contracts contain provisions that stipulate if you are in violation of certain of the loan’s clauses, you must repay the loan immediately. If this were to happen to you, it could end your business.
What are other Risks to Loan Stacking?
It can also be quite risky in other ways that could damage your business’ profitability and longevity.
A reasonable lender makes sure that you are only borrowing amounts that you can repay. They look at your total debt service coverage ratio, a measure of your debt obligations to net operating income. Through examining financial statements, business plans, and more, they will ensure that the loan is good for both of you.
Alternative lenders will ask about your monthly revenues and other business performance metrics. They will set up flexible daily, weekly, bi-weekly or monthly payments that work for your business to not hurt your cash flow.
The lenders who approach you just after you have taken out a first loan, offering to lend more without an application or credit check, are doing none of this due diligence. Your risk of default rises along with the more funds you borrow, but they are gambling that not everyone will default.
Another risk arises if you take out a loan because you are struggling to make payments on the first loan. It becomes a situation of robbing Peter to pay Paul when you are taking funds from one loan or line of credit to make payments on another. You would be far better off cutting costs, examining where your business plan went wrong and making adjustments. And then scale back, if needed, to get your business back on track rather than to start loan stacking.
Are There Options to Loan Stacking?
What if you are concerned about the risk of loan stacking, but still need more capital. You can try to refinance or negotiate your existing loans.
When you are first starting in business, without much credit, you may have had difficulty obtaining capital for reasonable interest rates and terms. While alternative lenders will lend to a company with less than two years in operation, you will pay higher interest rates to offset their risk.
Or, efforts to improve your credit score could have paid off, and revenues increased. If you think you could get better terms on a small business loan now, try re-financing your existing loan to free up working capital rather than loan stacking.
You can also negotiate for additional funds with your existing lender. If you have been on top of payments, they might be willing to raise your credit limit on a line of credit. If you have already paid off a portion of a loan, ask about options to take out more funds.
Try seeking out complimentary funding, instead. A business line of credit on top of a loan is not technically loan stacking. This is because you only make payments on a line of credit when you draw on it, and you can repay that money at any time. Once repaid, you have access to the funds again, unlike a loan where you would have to apply for another loan.
A business credit card could be a good form of short term business funding for day-to-day operations if you are waiting on customers to pay their invoices. Just make sure that you use that money to pay off the credit card when they pay. While loan stacking is discouraged, having different forms of credit is encouraged as they each serve a different purpose. Handled well, they can even boost your credit score.
What about Merchant Cash Advances?
While merchant cash advances do count as a form of loan stacking, they can be a less-risky version. A merchant cash advance is an unsecured loan on future business credit card sales. Lenders evaluated your credit card sales and lend on this amount.
Repayments are typically made by taking a small percentage of each credit card transaction run through your business until the loan is repaid. The lender charges interest on the amount lent, which is where they make their profit. Terms are usually one year, though they can be renewed if more than 50% paid down.
This fee is often reflected as a factor rate. For example, if you are charged a factor rate of 1.30, you will be paying back $130,000 on a $100,000 advance. Rates are quite high. So, why are they better than taking out a second loan if you need to stack business loans?
Because they’re repaid in small amounts out of your cash flow. A second term loan would require weekly, bi-weekly, or monthly lump sum payments which must be paid, regardless of your cash flow for that week. This can get a business into a lot of trouble if they have multiple, inflexible loan payments.
However, do make sure that you include the amount of your sales which will go to repayment in your budgets and cash flow forecasts.
Is Loan Stacking Ever a Good Idea?
Yes! You just have to be smart about it. You should always be able to closely tie the returns you expect to see from the loans to the funds you are borrowing.
Apply with a lender who will review your cash flow with both a first and second position business loan or merchant cash advance if you need to take out a third. In the case of a third position business loan, expect your repayment term to be short, between 60 to 180 days. But that may be just enough to get you over a bad spot.
The key to stacking business loans effectively is to be on top of your numbers. Where is the money going, what it is being used for, and when can you repay it. Keep detailed budgets and project plans, and track spending according to plan. If the second loan is meant to support a specific business initiative, consider putting the funds in a separate account and only paying bills related to that initiative from that account.
Reputable lenders have started to put processes in place to guard against excessive loan stacking. They know that, if done improperly, it hurts both the lender and the borrower. If you are considering taking out a second position business loan or a third position business loan, reach out with a reputable alternative lender such as Shield Funding. They will help you find the best product for you and your business.
Sam is an expert in small business financing and has been CEO at Shield Funding for more than a decade. The company has funded more than 1000 small businesses and has been a significant contributor to the phenomenal growth that many of those companies have experienced.