The Disadvantage & Advantage of Short-Term Financing

Too much short-term financing can be dangerous for small businesses.

Too much short-term financing can be dangerous for small businesses.

If you have a small business, you might find yourself short of cash from time to time. You might also have ambitious plans to grow your business. Either way, one way to get the money you need is to borrow it. A short-term loan is repayable within a year, whereas a long-term loan isn’t due for more than a year and perhaps much longer.

Interest Rates

Short-term interest rates are usually lower than long-term ones. You therefore pay less interest for a short-term loan because of both the lower interest rate and the shorter amount of time you’ll be paying interest. Short-term loans can be faster to obtain if they are relatively small, as they often are, because lenders do less underwriting (that is, evaluating your creditworthiness) for small loans. These loans can be used to plug cash shortages resulting from unexpected expenses, sales shortfalls, seasonal effects or other reasons.

Lines of Credit

Frequently, businesses set up lines of credit that allow them to borrow money quickly when it's needed and then pay it back at their own pace. A line of credit allows you to borrow and reborrow money up to the credit limit and only pay interest on the money you actually borrow. This is a convenient and flexible short-term borrowing technique that lets you minimize your interest costs. However, the interest charged on these lines can vary over time.

Alternative Lenders

Banks are the usual source of long-term business loans, but short-term loans are available from alternative sources, such as online and peer-to-peer lenders. A peer-to-peer loan is arranged on a website where borrowers and lenders come together and negotiate terms. The growth of the alternative lending industry has given small businesses, even ones with less than good credit, more opportunities to get short-term loans. Competition among these lenders helps to keep interest rates relatively low.

Risk

It can be expensive to use short-term loans to pay for long-term projects. The reason is that a long-term loan locks in the current interest rate. During normal economic times, interest rates rise over time. If you make a series of short-term loans to finance a long-term project, you may have to pay a higher interest rate with each loan, thereby increasing the cost of the project. Another risk of using a series of short-term loans is that your company might be in worse shape when you need to renew the loan. Depending on the circumstances, you might have to pay a much higher interest rate. In the worst case, you won’t be able to renew the loan at all. Had you initially taken out a long-term loan, this problem wouldn’t occur.

 

About the Author

Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.

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