In a recent study, 33% of small business owners said that one of their top challenges is getting enough working capital. If you’re one of the thousands of entrepreneurs in this group, you’ve probably thought about getting a business loan.
There are many resources to help you apply for a business loan, but before you start that process, you have to answer the following question: “Is getting a business loan the right decision for my business?”
Here’s how to calculate the answer.
Is it “good debt”?
In personal finance, debt is roughly sorted into two categories: “Good debt” and “bad debt.” The gist of the difference is that taking on good debt is likely to increase your long-term financial health, while bad debt is likely to decrease it.
For example, a mortgage is generally considered to be good debt, since it allows you to purchase an asset (a house) that can increase in value over time. Using credit cards or payday loans to cover day-to-day expenses will create bad debt, since these loans have sky-high interest rates and the items you’re buying don’t have any long-term value.
The tricky thing is sorting each debt into the proper category isn’t always that easy. Getting a mortgage is often a good financial choice, but not always; if the real estate market tanks, or the property isn’t a good value, or you can’t really afford it, or the interest rate and other loan terms are poor, it’s actually bad debt masquerading as good debt. Investing in your education can be a good decision, but if you graduate with $60,000 in student loans and your salary is $40,000 a year, you’re going to have a hard time repaying those loans while achieving other financial goals.
If you’re thinking about getting a business loan, you need to make sure that you’re only taking on good debt. The loan should increase the long-term worth and financial health of your business. That means all the following things should be true:
- The capital from the loan must allow you to increase profits.
- The cost of credit (I’ll cover that more in a bit) must be less than the increased profits.
- You’ll be able to repay the loan without jeopardizing future financial goals and opportunities.
If you can confidently say “yes” to all three of these conditions, you can stop right now and go get that loan. If not, keep on reading.
Will more money allow you to earn more profits?
We recently held a webinar with Sean Salas, founder and CEO of Camino Financial. He shared a lot of useful advice about getting your first business loan, and one of his tips was that you should only get a loan in order to earn more money—not to get yourself out of a bad spot.
If you can clearly show that more capital will allow you to increase profits, it makes it easy to calculate the costs and benefits of the loan. Lenders also love lending to financially healthy, profitable businesses, so you’ll be more likely to get approved for a loan and you’ll probably get a better interest rate.
Sometimes you do need money to get through a tight spot, however. If that’s the case, I recommend looking at it like this: If your business is generally profitable, and getting a loan will allow you to remain profitable, the debt is still allowing you to make more money even if it’s not exactly increasing profits.
What if your business doesn’t exist yet? If you’re looking for a startup loan, make sure you have a business plan with realistic financial projections. You can use that plan to calculate whether or not a loan will increase your long-term financial wellbeing.
Let’s talk about the cost of credit
When you get a loan, you’re paying someone for the use of their money.
The costs might come in the form of interest or fees associated with the loan itself (such as origination fees, early repayment fees, late payment fees, etc). Here’s a great article from NerdWallet on how to evaluate the different costs associated with business loans.
The cost of credit is one of the primary things that separates “good debt” from “bad debt.” You might have all the right reasons for getting a business loan … but if the cost of credit is too high, getting a loan is still the wrong decision.
The cost of credit is usually determined by many factors, including the following:
- The market Prime Rate (which is the rate that banks charge their best customers)
- Your personal credit
- Your business financials
- How long you’ve been in business
- The specific type of loan
- The lender you choose
Rates and fees aren’t everything
This article covers average interest rates for 2019 as well as the different factors that will affect your rate.
Another potential cost that isn’t always discussed is opportunity cost. If you have limited capital to work with (and pretty much everyone does), there are many ways to use that capital. For example, you could buy new inventory, or hire new talent, or invest in equipment, or pump money into advertising. If you get a loan and spend that money now, you may not be able to invest in future opportunities.
So, when you’re calculating the cost of credit, you should think about your long-term business goals and make sure you’re spending the right amount, on the right things, at the right time.
That’s why you need a business plan that outlines your long-term strategy and financial goals; with a carefully-considered plan, you can feel confident that you’ve explored all the probable opportunities and you’re pursuing the right one.
Time to crunch the numbers
Phew. If your head is spinning from all the math and soul-searching that the last few steps required, I have good news: you’ve finished the hard part.
Once you have calculated how much the loan will earn (increased profits or reduced costs) and how much it will cost (in interest and other fees), you’ll know whether or not a business loan will help or hurt the long-term financial health of your business.
At this point, it’s easy to decide whether or not to start submitting loan applications—and whatever your decision is, you’ll know it’s the right one.
Disclaimer – This content is for informational purposes only and does not constitute tax, accounting, legal, or other professional advice. Please do not rely on this content for any specific purpose without obtaining personalized professional advice.