Pros and Cons of
Payroll Loans

Last Updated on April 3, 2024

Shield Funding Team

Table of Contents

Pros and Cons

For many small business owners, payroll is their most significant monthly expense. Failing to make payroll, or bouncing a payroll check, can have serious implications for your business. Employees could quit, you could face fines or lawsuits, and the reputational damage could impact customer relationships. 

If you have doubts about your ability to cover payroll obligations, taking out a payroll loan could be a smart move. But, since there are pros and cons to payroll loans, be sure you know how the loan will impact your business before you apply.

What are the Pluses of a Payroll Loan?

Here are the circumstances when taking out a payroll loan would be beneficial to your business.

Retains employees

Employees count on their paychecks to pay their rent or mortgage, car payments, and other expenses. If you constantly struggle to pay them on time, or at all, they’ll likely look for work elsewhere. 

With a business loan for payroll, you can borrow quickly and avoid any disruptions in payroll. Many payroll loans fund within 24 hours, so if it doesn’t look like you can cover payroll on Thursday you’ll have the funds by Friday’s paycheck run.

Avoids Having to Cut Costs

If it looks like you’ll miss making payroll, you could cut costs elsewhere to free up the cash. 

A restaurant might reduce their liquor order for the weekend, or a retail store could wait on placing an inventory order. But cutting costs could harm your business in the long run. You’ll miss out on sales, or customers could take their business elsewhere, if you don’t have requested items on-hand.

With a payroll loan, you can meet your payroll obligations but continue to run your business as normal.

Allows you to offer net-30 terms

Small businesses have to pay employees weekly or bi-weekly, but most clients prefer to pay in 30 to 60 days. Unless you have built up a cash reserve, this cash flow pattern can cause issues. And if you’re constantly dipping into your cash reserve, eventually it becomes unsustainable.

Payroll loans are one solution that allow you to offer competitive terms to your clients while still keeping employees happy. 

Helps you deal with cash shortages

Sometimes, you run out of cash for working capital needs due to circumstances beyond your control. A client doesn’t pay on time, or their check bounces. A bank holiday holds up credit card receipts. In these cases, a payroll loan can fill in the gaps. 

Easy approval process

Applying for a traditional bank loan can take months – between documentation requirements and underwriting you could be out of business by the time you hear back! A payroll loan has fewer underwriting requirements and can fund quickly. An easy approval process means less time dealing with a bank and more time running your business. 

When are the Cons of a Payroll Loan?

In some cases, a working capital loan or merchant cash advance might meet your needs better. Here are the downsides to a payroll loan.

Funds can only be used for payroll

Payroll loans have one intended purpose – to cover payroll obligations. You cannot use the funds for another reason. For example, if you’re also unable to cover a portion of rent you can’t use a payroll loan for both payroll and rent. 

If you have funding needs beyond payroll, consider applying for a working capital loan instead.

Short repayment periods

Payroll loans meet temporary, emergency needs. Lenders offer them with a short repayment period, sometimes just weeks or months. A shorter repayment term means a larger loan payment, and this could further harm your business’ cash flows. 

The payroll lender could require that you give them a postdated check in the loan’s total amount. If the check bounces, you’ll incur bank fees and the lender’s fees. 

Payroll loans have high interest rates

Anytime you need funds quickly, you’ll pay more to borrow. This is because lenders don’t have as much time to fully vet your business. They’re taking on more risk with your loan, and will compensate for this risk by charging a higher cost of capital. 

Payroll lenders could charge anywhere from 15% to 45% for a payroll loan. 

Payroll loans could lead to a debt cycle

Falling into a cycle of borrowing can harm your business’ future. Once you take out a payroll loan, make sure you have a plan to pay it off. Otherwise, you could fall into the trap of continually borrowing to cover payroll obligations.

A debt cycle can prove expensive, and further exacerbate cash flow problems

Payroll loans can hide other business problems

Sometimes, borrowing can hide underlying problems in your business. Perhaps you need to focus more on collections, or hire a better bookkeeper. Maybe some employees aren’t working efficiently.

If you’re frequently taking out payroll loans, look at other aspects of your business which could be contributing to the borrowing need.

Factoring requires quality invoices

Invoice factoring is a form of payroll financing where the lender advances you funds based upon your past due invoices. If you work with a lender who offers this type of payroll loan, you’ll have to supply them with customer invoices. This additional documentation requirement can delay the time until funding. 

As well, the lender may want to verify the credit quality of your customers before advancing you funds. They could also want to check the invoice’s legitimacy. 

When is a Payroll Loan Right for Your Business?

If the pros of a payroll loan outweigh the cons, ask yourself the following questions.

  • Can my business repay the loan? 

Before borrowing, you should be sure that you can repay the loan. Will future cash flows support repayment? What if a key customer continues to pay late? If you have any uncertainty about your business’ ability to repay the loan, think twice about borrowing. 

  • Do I have good credit?

If you have a low credit score, it could be difficult to qualify for a payroll loan. While some lenders will work with borrowers who have scores as low as 500, you’ll pay more for the loan. If you know that you have poor credit, apply with lenders willing to extend credit to someone with your score. 

  • Are there any prepayment penalties?

With a traditional, amortizing loan, you save on interest if you pay it off early. But many payroll lenders want to protect their profit. They charge prepayment penalties or the full interest on the loan regardless of when you pay it off. 

If you’d hoped to pay off the loan early and save some money, work with lenders who don’t charge prepayment penalties.

How to Qualify for a Payroll Loan

Wondering how you can qualify for a payroll loan? You’ll need to meet the following requirements:

  • At least three months in business
  • A credit score at or above 530
  • Minimum monthly business revenues of $10,000

Some lenders could have additional qualification requirements, depending on the type of financing. 

Is a Payroll Loan Right for You?

The pluses to a payroll loan often outweigh the minuses – particularly if your business depends on highly-trained and skilled workers. If the costs of finding and training replacements for employees who leave when you fail to make payroll are greater than the loan’s cost, a payroll loan is a good choice when considering all your business loan solutions.