Debt Financing: Definition and Types

Debt Financing for Business

When your business needs money, there’s no shortage of options for how you can go about getting it. You might be tempted to use invoice factoring, get a merchant cash advance, ask a friend or family member for a loan, or dip into your retirement fund to help your business grow. But with all the options out there for funding a business, one of the most widely-used methods is debt financing.

What Is Debt Financing?

In the simplest terms, debt financing is when you take out a loan to fund your business, which is then repaid with interest over time. In other words, debt financing is what most business owners would call a business loan. Depending on the type of loan you choose, it may be short-term funding that’s intended to be paid off in a matter of months or a long-term loan with terms of several years or decades. Unlike equity financing, debt financing does not involve taking on any extra business partners or giving up any amount of control of your business operations to another person.

Examples of debt financing include mortgages on real estate, credit cards, bank loans, and even borrowing money from family and friends. In essence, debt financing includes any financing option where you receive money upfront and repay the amount over time with interest. Each financing option comes with different rates and terms, which are typically based on your business’s qualifying criteria.

Types of Debt Financing

There are several different options for debt financing available. Which one is best for you and your business will depend on your situation.

Short-Term Business Loans

Short-term loans can be an option for businesses that don’t need a large amount of money. Many businesses that apply for business loans are rejected because they are seeking too little money for the lender to see it as being profitable enough. But since short-term loans often have terms of a year or less, they’re very commonly given for smaller amounts of money and are best for handling temporary setbacks and short-term expansion projects.

Unsecured Business Loans

Large, long-term loans typically require the borrower to pledge a major asset as collateral, but unsecured business loans do not have that requirement. However, be aware that an unsecured business loan simply means that the lender will not require you to have the collateral in order to be approved for the loan. If you default on an unsecured loan, it is still possible for the lender to seize assets to recover their losses.

SBA Loans

Small businesses often have a more difficult time getting approved for loans since many lenders see them as being a higher risk. To help encourage lenders to approve loans for small business owners, the Small Business Administration will agree to guarantee a portion of business loans for approved businesses. There are many different types of SBA loans available, including 7(a) loans, CDC/504 loans, microloans, and disaster loans.

Microloans

A microloan is another option for businesses that only need a small amount of money. In the United States, the average amount for a microloan ranges between $10,000 and $13,000. Unlike many other types of business financing, microloans are also available to startups, very young businesses, and businesses that have never borrowed money from a bank before.

Merchant Cash Advance

Small businesses are often season or have fluctuating revenues, which can make it difficult to keep up with fixed payments. Merchant cash advances provide an advance in exchange for an agreed-upon percentage of future revenues or credit card sales. Merchant cash advances come in various forms and often have shorter durations and smaller regular remittance amounts than business term loans, making them ideal for small business owners who need flexibility to satisfy their advance.

Equipment Financing

Equipment financing allows business owners to loan, lease to purchase or borrow hard assets for their business like machinery and other equipment. Rather than paying for the assets in full upfront, equipment financing allows you to receive the equipment you need now while allowing you to pay for the asset over its lifetime. Equipment financing comes in various forms and many of them are easier to qualify for than other debt financing options.

Advantages and Disadvantages of Debt Financing

Like any other financing option, debt financing has its pros and cons.

Debt Financing Advantages

While equity financing allows you to get funding for your business without going into debt, the trade-off is that you have to give up a level of control over your business. Debt financing allows you to maintain total control over your business, even if you do incur debt. But taking on debt does have its benefits since successfully paying off a business loan can help your business build good credit.

Interest rates for debt financing will vary depending on the type of loan you have. Long-term business loans have the lowest interest rates but take longer to apply for and have the strictest requirements. Short-term loans have higher interest rates and are generally given for smaller amounts of money, but are faster to apply for and are more accessible to many types of businesses.

Some types of debt financing can be harder to get than others. Business owners interested in a larger long-term business loan will need to have higher credit scores, an established business record, and possibly collateral, which makes it difficult for small and young businesses to get them. Many types of short-term loans have more relaxed requirements about things like how long you’ve been in business and your business credit score.

Debt Financing Disadvantages

Although debt financing doesn’t involve giving up any level of control of your business, there is a chance you could lose valuable assets if you default on a secured loan. Unsecured business loans do not require collateral, but since they involve a higher risk for the lender, the requirements to get one are typically stricter and the interest rates are higher than with secured loans.

Having to make interest payments over time can cut into your profits, which will always cost more than if you could have funded your initiatives with your own capital. However, by borrowing money and repaying over time you can pursue new growth initiatives that take your business to the next level without having to give up equity.