Why you Should Think Twice About Using Credit Cards to Finance your Business
Business credit cards help small business owners stay afloat. In one survey, 31% of small business owners said they had used their card to meet capital needs in the last year.
The market for small business credit cards is $500 billion, and more credit card companies are working to reach small business owners. If an application has shown up in the mail, is it the right choice for your business? Before completing the application or entering an existing credit card to pay a utility bill, you should think twice.
Reasons you Might Want to Use a Business Credit Card
Business owners often use credit cards to cover cash flow gaps if a business loan for cash flow is not available to you. An example of a cash flow gap is if an invoice comes due before your customers have paid you. As long as you can pay off the charge before it comes due, this is an excellent use of credit.
Where small business owners can get into trouble is if they use a credit card for longer term needs. If your walk-in refrigerator broke and you need to purchase a new one immediately, it is tempting to reach for a card. But, in some financing situations, you should think twice about using a card.
Interest Rates and Late Fees can Hurt your Business
Despite having the best of intentions, you might not be able to pay off your balance before your bill comes due. If you use a credit card to fill a cash flow gap, you must be disciplined about paying off that balance when your customers finally pay. The reality is that other bills could come along in the meantime, and your credit card balance could slowly creep upwards.
Once your balance starts rising, so does the interest you pay. If you miss a payment, you will incur a late fee and your interest rate could go up. While you may have budgeted for your initial payment and interest, unpredictable increases could throw everything off. More and more of your business’s revenues will have to be put towards debt service, leaving you with less working capital to operate.
If you choose to take out a business loan instead, you will have both a fixed interest rate and fixed payments. You can budget for the loan’s impact upon your business’s cash flow and plan for repayment.
A Credit Card May Not be Enough
Credit cards have upper limits, and once you reach your limit you can no longer use the card to pay for expenses until you have paid down the balance. Upper limits on credit cards rarely go above $30,000 for a small business or an individual, but your business could have a larger need.
A large remodel or expansion will cost significantly more than a credit card’s limit, which would leave you in a bind. With large projects, you often must pay contractors or vendors prior to when the project generates any revenue. Because you will not yet be making money off the expansion, it could become a struggle to pay off your credit card. If you are unable to pay down the card’s balance throughout the month, you could run out of money to fund the expansion.
In that case, your options for a small business loan might become more limited. Traditional lenders are reluctant to lend more to someone who has already maxed out a credit card. If you have a budget and estimate, it would be easier to take out a small business loan to pay for your expansion. That leaves your business credit card free to cover daily expenses and ensures that you have enough capital to complete the project.
Credit Cards Are Not Meant for Long-Term Financing
Different financial products fill different business needs. Credit cards work best for short-term expenses, such as when you need to pay your liquor distributor before the weekend sales. They are not meant to finance long-term projects and are an expensive way to access capital.
Interest, fees, and maximums are all reasons why credit cards are not meant for long-term projects, but there is another consideration. If you have prepared a business plan for adding a new location, investing in a new product line, or a remodel you will need to track your spending. That way, you can gauge the project’s success and calculate your return on investment.
If you are using a credit card for both operating expenses and your business plans, expenses will become mixed. It will be harder for you to track project-related expenses, or to stay on budget. In contrast, if you have taken out a loan you can use those funds only for your project.
Credit Cards will Hurt your Credit Score
Applying for both a new credit card and a small business loan dings your credit score by five points, but a credit card can have worse implications. That is because the credit bureaus look at your credit utilization ratio when calculating your credit score, as well as your debt service coverage ratio.
A credit utilization ratio reflects the amount of your open credit you are using. If you apply for a card with a $30,000 limit and immediately charge $25,000, your utilization ratio is 83%. This will have a massive negative impact on your credit score.
While taking out a loan also adds to your available credit, with a loan it is expected that you will receive 100% of the funds. You are using the credit as expected, versus over-using a credit card. Loans are seen as a less risky form of credit because they have regular payments, versus the unpredictability of a credit card payment.
Credit mix is another component of your credit score. Credit mix is the mix of credit you have available to you between installment loans, credit cards, mortgages, and more. Again, loans are viewed more favorably than revolving credit like a card. Credit agencies treat them as a safer form of credit.
Your debt service coverage ratio measures the amount of free cash your business generates that can be used to service debt. If all of your free cash must service debt, lenders become wary of lending more. They know that if you had to cover an unexpected emergency you might default on a loan payment. Using a credit card now could make it harder to qualify for a better form of financing later.
Credit Cards Make it Harder to Track Cash flow
Along with tracking a project’s progress to budget, a small business owner should monitor their cash flow. Cash flow tells a story which could help you run your business better.
Maybe one customer always pays late, and you need to change their terms. Or you are running significant balances of past due invoices, and you need to examine your collection activities. A product that you expected to sell slowly has taken off, and you could sell more if you upped your inventory level. Regular cash flow monitoring helps you stay on top of problems before they get out of hand, and identifies potential growth areas.
If you are using a credit card regularly, however, cash flow monitoring grows difficult. This is particularly true if you are mixing personal and business expenses on the same card. Is your accounts payable balance really going down, or are you just paying bills with credit cards and shifting it to short term debt? Did your monthly expenses go up, or did you forget and pay a large personal expense on your card?
A credit card makes it too easy to spend money, and thus, harder to track your business’ metrics.
Should you Apply for a Bad Credit Business Loan?
A bad credit business loan has many of the advantages of a credit card without some of its drawbacks. The application process is quick, just like with a credit card. It can take as little as 24 hours for an alternative lender to approve your loan. You will also have almost-instant access to funds, as bad credit business loans disburse funds within one to two days or a week.
Interest rates on a bad credit business loan are comparable or better than a credit card, particularly if you have decent credit. Even if you do not, you can receive funding with a credit score as low as 500 making this capital more accessible than a credit card for borrowers with poor credit.
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