While running your small business, you could face an unexpected expense – your computer network crashes, a key piece of equipment breaks down, or you need to cover payroll after a downturn in business. In a moment of urgency, you may be tempted to take on high-interest debt instead of an affordable small business loan. This short-term fix can do more harm than good if you carry the high-interest debt for too long.
Here, you’ll learn the risks you’ll encounter when taking on high-interest debt, and you’ll find lower-cost solutions to refinance your high-interest debt and get the funds you need to get back on track.
What is considered high-interest debt?
High-interest business debt can be like financial quicksand, sinking your business into longer-term financial problems. This includes loans with interest rates over 20% or unreasonable repayment terms, such as daily or weekly payments.
Traditional bank loans and loans from reputable small business lenders typically have interest rates between 5% and 12% and require monthly payments. Anything significantly above this range should raise concerns because it limits you to paying only the minimum amount. As a result, you won’t be able to pay down the principal and get ahead of the debt.
How does high-interest debt happen?
Many small business owners fall into the trap of high-interest debt because it promises an easy solution during times of extreme financial pressure. This can happen when an essential piece of equipment breaks or you’re short of payroll and don’t have enough cash reserves.
However, getting access to funds can be crucial during a crisis, even if the long-term consequences are high-risk.
That’s understandable – and that’s why the key point here is what you do after the emergency has passed to resolve high-interest debt.
An example of how high-interest debt can happen
Let’s use an example of a bakery to show how high-interest debt could happen to you:
- One morning during a busy holiday season, your commercial oven breaks down. To replace, deliver, and install it immediately will cost $50,000 – money you don’t have saved. You also don’t have the time to shop around for loans – you need the funds now to get back to work. If you don’t, you’ll lose out on critical holiday orders. At that moment, the need for funding to buy the oven outweighs any concerns about longer-term financial impacts.
After a quick search, you find an online lender that doesn’t require any documentation and offers immediate financing with seemingly simple terms:
- Loan amount: $50,000
- Interest rate: 30% annually, compounded weekly
- Repayment term: 52 weeks (one year) automatically withdrawn weekly from your business checking account. That breaks down to weekly payments of about $1,116 and total interest of about $8,017.
Your bakery brings in $24,000 a month during the two-month holiday season, or about $6,000 a week. The weekly payment of $1,116 may not seem terrible at first glance, but it accounts for about 19% of your gross revenue during the holiday season.
When the holiday rush is over, your revenue typically falls to about $3,000 per week, meaning the loan payments will eat up more than 37% of your gross revenue – before payroll, taxes and insurance, rent and utilities, cost of goods, and any other debt are factored in. This will significantly strain your cash flow for the remainder of the year.
Lenders typically recommend that total debt payments shouldn’t be more than 30-35% of your gross revenue. In addition, over the course of the year, the pressure of high payments creates ongoing stress and limits your ability to focus on growing the business.
How to refinance your high-interest debt
When you take on high-interest debt to overcome an emergency, it’s all right if that scenario only lasts a month or two – but you need a plan to refinance as soon as possible to get your business’s financials back on track.
If your business is already struggling under the weight of high-interest debt, there are solutions. However, carrying high-interest debt for too long can impact your ability to be approved for a loan since it strains your cash flow and could negatively impact your credit history. That’s why it’s important to refinance as soon as possible.
The U.S. Small Business Administration (SBA) has several different loan programs specifically created to help small business owners. SBA loans are available through some banks, credit unions, and Community Development Financial Institutions (CDFIs).
Here are some of the SBA loans available to refinance high-interest debt:
- The SBA 7(a) loan program: This provides loans from $50,000 to $5 million for startups and growing businesses, with repayment terms of up to 10 years for most loans.
- The SBA Community Advantage loan: This is a special type of SBA 7(a) loan that’s designed to provide additional support for businesses operating in underserved areas, with loans up to $350,000.
- The SBA Microloan: Even if your business has a smaller amount of high-interest debt, it can still be hard to get ahead. The Microloan program provides loans from $10,000 to $50,000 that can be applied to paying off high-cost debt and many other uses. The application is simple, and decisions are often made within a couple of days, with funds in the bank within a week for approved applicants.
- The SBA 504 loan program: This provides long-term, fixed-rate financing up to $5.5 million for major fixed assets, including owner-occupied real estate and heavy equipment. The program can also be used to refinance debt from these business purchases.
With beneficial options like these, there are solutions that can help. When you’re ready to move forward, make sure that you understand:
- The interest rate and the annual percentage rate (APR)
- The length of the repayment term
- How much your regular payment will be
- Whether there are any hidden fees or penalties
- How frequently payment is required
It’s also important to know that in addition to getting affordable interest rates and repayment terms, the most beneficial loan repayment period is monthly. If you’re required to pay daily or weekly, this could be a ‘red flag’ that you are dealing with a predatory lender.
How to prevent high-interest debt
The best strategy to prevent a high-interest debt situation is to have enough money in your cash reserves to support you in overcoming urgent situations. Although, for many new businesses and even some small businesses that have been up and running for years, that’s not always easy.
The good news is that there are financial strategies that you can use to protect yourself from high-interest debt. Here are some steps you can take:
- Open a business line of credit: A business line of credit lets you borrow money when your business needs it most. A line of credit is similar to a credit card in that you can use any amount up to your borrowing limit, but you only pay interest on the funds you’ve used each month, along with a portion of the outstanding balance. It can also help you build a strong business credit history.
- Keep a business credit card available: Although business credit cards can have high interest rates, if used responsibly, they can be a lifesaver when you need to make purchases on the spot. The key to using credit cards is to ensure that you pay them in full each month – and if you can’t, talk to a small business lender about refinancing the balance with a lower-cost loan. Then, ask your credit card company or bank to lower your credit limit so it’s only available for smaller emergency purchases.
- Get a working capital loan: Having enough working capital allows you to manage your finances better and position your business for future growth because you can reinvest more revenue into your business. Responsible small business lenders have working capital loans with terms that make them easier to repay while giving you a cash cushion that smooths out cash-flow cycles and can get you through urgent situations.
A need for quick cash today doesn’t have to mean financial struggle tomorrow. If you find yourself taking on high-interest debt to get through a financial crunch, remember that if you refinance as soon as possible, you can prevent it from becoming a long-term financial challenge. If it’s a cycle that keeps repeating, you may need to rethink your revenue and cash-flow strategies, expenses, and operational efficiencies to better manage your finances.
If you have high-interest debt for your business, Pursuit can help
High-interest business debt is more than just an expense – if it’s not refinanced, it can become a threat to your business’s success. By understanding the risks, exploring your refinancing options, and making informed decisions, you can protect your business’s financial future.
If or when you find your business has taken on high-interest debt, Pursuit can help. For businesses in New York, New Jersey, Pennsylvania, Connecticut, Nevada, Illinois, and Washington, we offer more than 15 loans and a line of credit for equipment, real estate, working capital, refinancing high-cost debt, and more.
Contact us to learn more about how we can help you.
