Debt Financing: What It Is and The Pros and Cons | American Express (2024)

If you’re a small business owner, it’s quite likely you might need some additional cash to purchase inventory, hire help, or buy equipment that will streamline your processes. In most cases, debt financing offers a solution.

What is debt financing?

Debt financing is the technical term for borrowing money from an outside source with the promise to return the principal plus the agreed-upon percentage of interest.

Most people think of a bank when they think of this type of borrowing, but there are many types of debt-financing providers available to small business owners.

Types of debt financing include:

• Business loans
• Business lines of credit
• Credit cards

Advantages and disadvantages of debt financing

Before you pursue any type of financing, you should consider the advantages and disadvantages of leveraging your debt to grow your business. This way, you can be prepared for the potential benefits and risks of each option and choose the best solution for your business.

Benefits of debt financing

Debt can be a healthy, revenue-generating tool for your business. Here are some advantages of debt financing:

• Maintaining control of your business – Seeking investors is one way to finance your business, but you may have to contend with someone else’s vision for your business. If you prefer to call the shots for your business, it might make sense to leverage debt financing.
• Keeping tax deductions – In many cases, the principal and the interest payments on business loans are classified as business These can be deducted from your business income taxes.
• Lowering effective interest rates – Tax deductions can affect your overall interest Because of the tax write-offs of debt financing, your effective interest rate is lowered.

Drawbacks of debt financing

The biggest debt financing risks include:

• Paying back the debt – Business debt financing can be a risky option if your business isn’t on solid If you are forced into bankruptcy due to a failed business, your lenders may have the first claim to repayment before any other stakeholder, even if you have an unsecured small business loan.
• Having high interest rates – Interest rates vary based on various factors including your credit history and the type of loan you’re trying to obtain. However, even after calculating the discounted interest rate from your tax deductions, you may still be paying a high interest rate each month that cuts into your profits.
• Affecting your credit rating – What you borrow affects your credit And this effect can be negative if you’re borrowing large sums without repaying them quickly. This translates into higher interest rates and more risk on the part of lenders.
• Navigating cash flow difficulties – No matter how much your monthly sales vary, lenders typically expect equal monthly This can pose a real challenge that can lead to late payments or even defaults which can harm your credit over the long term.

Alternatives to traditional debt financing

Debt financing isn’t the only solution for small businesses that need to access funds and improve cash flow. Some alternatives to traditional debt finance options include:

• Working capital loans – These can help finance day-to-day business operations. These unsecured loans, provided by alternative lenders and certain banks, are typically most helpful for covering short-term, immediate
• Merchant cash advances – These allow you to access upfront working capital in exchange for a percentage of your future credit card sales.
• Peer-to-peer (P2P) lending – This financing lets you borrow directly from other business owners by using a P2P lending site. P2P loans can come with higher interest rates and longer application processes, but more flexible terms.
• Microloans – These are like regular business loans, but they cover smaller dollar amounts, such as $500 to $10,000, and often have shorter repayment terms — even less than a Microloans are an option for business owners who are just getting started and still building their credit but have a strong business plan for future growth.
• Grants – The U.S. Small Business Administration (SBA) and other government organizations offer grants for many different types of companies. Certain grants are also created specifically for women, minorities, innovative research, and disaster relief.
• Crowdfunding – Supportive community members help you grow your business. You can use a crowdfunding platform to manage this process and reward donors with perks.

How a line of credit can help finance your business

Traditional debt financing can help small businesses cover expenses, purchase equipment, and fund day-to-day operations. Just remember to consider the advantages and risks of debt financing before choosing a solution for your business. Business loans, for example, can help you access funds without taking on new investors, for example, but they may also come with interest rates and strict repayment terms.

A business line of credit, by comparison, is more flexible than many other types of debt financing. With a business line of credit, you access money as you need it, and only pay fees on what you use if you have an outstanding balance. You can withdraw funds for immediate financing and have cash on-hand to fuel future growth.

Learn more about how to fund your business with a flexible line of credit.