What Is a Short-Term Business Loan? A Definitive Guide

This article originally appeared on The Financially Independent Millennial and was republished with permission.

Short-term business loans differ from other kinds of installment loans. How do you know if using a short-term loan is correct for the business?

In this definitive guide, you’ll learn how short-term business loans work, the types of loans available, the benefits of short-term business loans, and the potential pitfalls!

What Are Short-Term Business Loans?

A short-term business loan is like a traditional installment loan. But the repayment period is for a shorter term and a different method applies when calculating fees.

Repayments for traditional installment loans apply an interest rate. However, a short-term business loan does not rely on interest rates. Instead, short-term business loans use a flat fee or a factor rate. These fees may appear as a percentage or a multiplier. Like interest, these fees are a percentage of the borrowed amount.

The key difference between interest rates and fees is that a short-term loan only has the fee added once. That means when arranging a loan, the business knows exactly how much will have to be repaid. Provided the business is happy with the repayment amount, the loan can go ahead.

Look at this example:

The business borrows $20,000 and the factor rate is 1.35. This means the fixed fee is $7,000 and the total amount to be repaid is $27,000.

Factor rates range between 1.09 – 1.6 or 9% – 60% of the amount borrowed. Some loans may incur higher or lower rates depending on circumstances. Other fees may also apply such as an origination fee.

Short-term loans also use a different repayment method to traditional loans. Rather than paying a monthly amount, repayments will be daily or weekly. The payments automatically come out of the business account in line with the loan agreement.

Are Short-Term Business Loans the Right Option For Your Business?

Many businesses enjoy using short-term loans. Yet, there are occasions when a short-term loan is not the best choice. Understanding these loans is key to making the best decision to meet the business needs.

Who Can Qualify For The Loans?

Each lender will have its own unique requirements the business must meet before offering a short-term business loan. Generally, the requirements are not as strict as those that a bank has when asking for a traditional loan.

One of the main factors is the cash flow of the business. Lenders want to see that the business can support repayments on a daily or weekly basis. Once they’ve seen this, a loan application is much more likely to be successful. Unlike traditional loans, bad credit isn’t as important provided cash flow and other criteria are good.

Other factors that are important to securing a loan include:

The credit profile of the business, business bank account information, and annual revenues. Also, how long the business has been operating and the personal credit score of the business owner.

Most lenders are going to need all this information, although there may be some that ask for more or less than this.

How Long Are the Terms?

As implied by the name, a short-term business loan is not over an extended period.

On average, short-term loans range from six to 18 months, but most are for 12 months or less.

Types Of Short-Term Business Loans Available

To choose the best short-term loan for the business, it’s important to understand the options available.

Business Loan

Short-term business loans are a lump sum with a fixed amount up front. These loan types also have a specified amount of time for repayment. Repayment schedules vary between 6-18 months with most less than 12 months. Payments are daily, weekly, or as otherwise agreed.

Small business owners find that acceptance for a short-term business loan is much easier than for long-term loans offered by banks. This is because the criteria for acceptance are not as strict.

Business Line of Credit

A business line of credit is a constant open line of credit. This type of short-term lending allows small business owners to withdraw funds when needed. The agreement will have a credit limit and charges principal and an interest rate.

Term lengths aren’t stipulated for a business line of credit. Instead, the agreement needs extending on an annual basis or as otherwise agreed.

The flexible nature of having a business line of credit makes this option a good choice for businesses that need to have access to capital.

Business Cash Advance

A Business Cash Advance is an advance given to the business based on expected future sales. The business will need to pay back a fixed amount that will be higher than the amount advanced.

The amount to be repaid doesn’t include interest. Instead, a factor rate applies. A set amount must be repaid as agreed at the time of taking out the advance.

To repay a Business Cash Advance a percentage of future sales gets collected. These payments get taken daily, weekly, or as otherwise agreed. Term limits do not apply when receiving a Business Cash Advance. This is because the business is not taking out a loan. Instead, the business is getting an advance against future receivables.

Business Credit Card

A business credit card works exactly like a personal credit card. The business has an open credit line and charges a principal plus interest.

The company receives a plastic card to use for purchases or making other payments. These can be fantastic for companies needing an on-demand payment method.

Merchant Cash Advance

A Merchant Cash Advance is when a business gets an advance against future sales. It’s like a Business Cash Advance but uses a different repayment method. Merchant Cash Advances only take payment from future credit card sales, not total sales.

The Merchant Cash Advance will continue to take a percentage until the full amount is repaid.

Invoice Financing

Invoice Financing is when a business gets an advance against invoices that are outstanding. Small businesses can get an advance in exchange for a fee. The Invoice Financing company will then be responsible for collections.

Using this method can be good for small businesses as it’s a fast way to get capital. It also means the business doesn’t have to spend time collecting the invoice as this is done by the Invoice Financing company.

Purchase Order Financing

Purchase Order Financing gives businesses a way to raise capital to pay their suppliers for verified purchase orders.

Using this option frees up cash flow that would otherwise be set aside for use elsewhere. A business can finance part of an order or the whole order using Purchase Order Financing.

When the order gets shipped, the supplier requests payment. The purchase order finance company advances the money to the supplier. They also collect payment from the customer. The finance company operates as both a collection company and an advancing company.

Benefits of Short-Term Business Loans

Short-term business loans can sometimes be a better choice than traditional loans.

Many traditional financing options take a long time for approval. short-term financing is a faster way to get cash flow for the business. When the business needs cash quickly, a short-term loan can be the ideal solution.

Short-term business loans are much easier to get than other loan products. Credit scores aren’t as important which makes getting accepted much easier.

Businesses that don’t need to borrow a large amount can enjoy using short-term loans. These loans mean the business can borrow a reasonable amount to pay back daily or weekly.

Drawbacks of Short-Term Business Loans

The biggest drawback of a short=term business loan is that the business may not get the capital it needs. If the business needs a significant amount, then using long-term credit solutions may be a better option.

Before applying for any business loan make sure that the financing needs of the business get examined in detail. Lenders that operate in the short-term business loan space have lots of options available. Make sure due diligence gets completed before agreeing to any loan offer.

Conclusion

Choosing the right short-term business loan may seem daunting as there are a huge variety of products available. Take time to research the market and ask questions to help choose the right option.

When starting the search for a short-term loan, don’t be afraid to ask tough questions. Are the rates and costs competitive? Were all funding options explained?

Make sure to spend time checking every detail. Check offers, terms and conditions, all fees including closing and originating fees, the length of the loan, and all other pertinent information. Checking all this before agreeing to the loan reduces the chance of making the wrong loan choice.

Getting the right loan for the business means a much higher chance of a successful future.