Most business loans are issued for the purpose of financing business investments, assets, and business expansion. Working capital loans differ in some key respects, including their purpose (covering day-to-day expenses like accounts payable, payroll, repairs, and unexpected expenses) and the duration of their repayment period, which is typically much shorter than a traditional business loan. They can be easier to obtain than larger, longer-term loans, but can also carry certain disadvantages of which the borrower should be aware.
Types and Purposes of Working Capital Loans
There are multiple types of working capital loans, each with its own repayment terms, and many with different purposes.
- Bank Overdraft Facility / Line of Credit: This loan works as a revolving line of credit that's extended over and above a business's available balance. Interest rates are generally low (between 1 and 2 percent over the prime rate), and interest is only charged on the amount of the overdraft. It requires a better credit rating than many of the other types of loans listed below.
Short-Term Loans: Here, the funds are disbursed under a fixed payment period (usually twelve months) and a fixed interest rate. While this type of loan is generally secured, it's possible to get an unsecured short-term loan if your business has an excellent credit rating.
Accounts Receivable Loans: Especially popular among non-traditional lending companies like Kabbage and PayPal, these loans are secured against your company's future receipts. While they can be useful in meeting spikes in customer demand, they're also more difficult to qualify for since they are not typically issued to companies that have not already proven their ability to pay their debts.
Factoring / Business Cash Advance: Similar to an Accounts Receivable loan, except that in this case, the loan is issued against a business's future credit card receipts.
Trade Creditor: Rather than being issued through a bank or non-traditional lender, trade creditor loans are typically offered from one partner in a transaction to another, extending credit on the basis of the recipient's credit rating and purchase needs. In some respects, a trade creditor loan is the business equivalent of a consumer line of credit at a department store, but for business purposes.
Personal or Investor Equity Funding: If you've exhausted your other options, or have tried to obtain a loan by other means and failed, it's not uncommon to tap home equity, or to turn to friends, family, or other outside investors. This is common for startups and less-established businesses that haven't yet built a credit history.
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Applying and Qualifying for a Working Capital Loan
The application process for working capital loans is typically quicker and a bit less onerous than for other types of business loans. You will need to have your business's finances in order, since your business's credit rating (and/or yours, especially if you're just starting out) will be taken into consideration, and your business's finances gone over in some detail to ensure your ability to pay. Businesses will typically need good credit and a demonstrated ability to pay (whether via a past history of loan payments, or consistent accounts receivable) to qualify.
Working Capital Loan Rates and Terms
The rate at which money is lent will generally be determined by a few factors:
- Type of Loan
- Credit Rating
- Payment History
- Amount Borrowed
- Loan Term
The rates charged vary widely, from 1-2% over the prime rate for certain loan types issued to businesses with excellent credit, to 8-10% or higher for subprime borrowers.
Working Capital Loan Providers
Working capital loan providers fit one of two categories: traditional and non-traditional lenders. Traditional lenders include the SBA (which acts as a loan guarantor), banks and credit unions. Non-traditional lenders are for-profits that often specialize in working capital loans, or act as lenders for other types of loans as well. Non-traditional lenders will often offer easier approval, but at higher interest rates than those offered by their traditional counterparts.
Traditional lenders include most major banks, such as TD Bank, Bank of America, HSBC, and others. The SBA maintains a list of working capital lenders with whom they work by state, but if your bank offers business services, odds are better than even that they offer working capital loans. Non-traditional lenders include the likes of PayPal, OnDeck, Kabbage, Lendio, and others.
Pros and Cons of Working Capital Loans
Faster Application and Approval: The process from application to approval for a working capital loan can be as brief as 48 hours. In most cases, the application and approval times are much shorter than for longer-term loans.
Flexibility: Working capital loans tend to be issued with fewer restrictions on their use.
Short Terms: Small amounts of money borrowed means a shorter repayment term. That means taking on debt only for a short time and not being tied down by payments over the long term.
Interest: The rates of interest for working capital loans can be much higher than a traditional loan, especially when issued by a non-traditional lender. While a normal business loan will carry an interest rate that's typically only a few percentage points over the prime rate, working capital loans are often issued at interest rates as much as ten percent over prime. That rate can go much higher still, especially for unsecured loans. This can make a working capital loan an expensive proposition.
Possible Credit Damage: Remember that taking out loans of any kind too often can damage your credit rating.
Short Repayment Terms: Why is this listed under both Pros and Cons? When you take out a working capital loan to cover a shortfall, it can be easy to take out another loan to ensure that you're meeting payments on the first, or to find yourself in the same position yet again when the first loan is exhausted.
Working capital loans can be an excellent way for businesses to cover small one-time expenses, or to deal with cash flow issues that arise unexpectedly. They offer flexible use and payment terms, and can be a viable option under the right circumstances. However, their short payment terms coupled -- in some cases -- to higher-than-average interest rates can easily lead to a cycle of borrowing and repayment that can damage credit as well as being difficult for businesses to break out of.