Debt Financing: How It Works, Types, Pros & Cons - NerdWallet (2024)

Debt financing is when you borrow money to finance your business. You agree to pay back the creditor the funds borrowed, plus interest, by a future date. Debt financing differs from equity financing, in which you raise capital by selling partial ownership in your company.

You can get debt financing, such as small-business loans, from traditional lenders, online lenders, fintech companies and even friends and family.

How much do you need?

We’ll start with a brief questionnaire to better understand the unique needs of your business.

Once we uncover your personalized matches, our team will consult you on the process moving forward.

What is debt financing?

Debt financing involves securing money for your business by taking on debt. Generally, you’ll receive a lump sum of money that is repaid over time with interest. Bank loans, SBA loans, lines of credit, commercial mortgages and equipment loans are common options used in debt financing.

The money you received for your business can be used as working capital, to buy assets and for a variety of other purposes. Sometimes debt financing is secured by collateral — business assets such as equipment, real estate and accounts receivables — that can be seized if the debt is not repaid.

In relation to accounts receivable, debt financing is not the same thing as debt factoring where a business sells their accounts receivable to a third party instead of using them as collateral.

How debt financing works

Debt financing can be structured in the form of an installment loan, revolving loan or cash flow loan:

  • Installment loan. You receive funding from a lender upfront and repay it, with interest, over a fixed payment schedule. Also referred to as traditional term loans, these loans may be secured or unsecured.

  • Revolving loan. You have access to a set credit line that you can draw from and use as needed. You only pay interest on the funds you use, and once you’ve repaid what you’ve borrowed, your credit line resets. Credit cards and lines of credit are examples of revolving loans.

  • Cash flow loan. You receive an advance of funds based on your business revenue. Some lenders may consider your business bank account data, while others may look at your recent cash flow and offer funds against your future sales. Invoice financing and merchant cash advances are both examples of cash flow loans.

You can choose either short-term or long-term debt financing — based on a variety of factors, such as how you plan to use your funds, what type of loan you’re looking for and how much time you'd like to be given to repay your debt.

Short-term debt financing

Short-term debt financing typically has a repayment period of 12 months or less — although standard terms can vary from lender to lender. Credit cards and business lines of credit are popular forms of short-term financing.

This type of funding is often used to cover the day-to-day operating expenses of your business. You might use short-term debt financing for working capital, to purchase inventory or to make payroll.

Long-term debt financing

Long-term debt financing generally has repayment terms up to 10 years, and in some cases, as long as 25 years. Common forms include bank and SBA loans.

Long-term financing is used for larger projects and investments, such as equipment purchases, business renovations, acquiring an existing company or opening a new location.

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Types of debt financing

There are a variety of funding options to choose from when financing your business with debt. Here are some of the most common types of debt financing.

Business term loans

Business term loans are one of the standard types of debt financing and operate similarly to a car loan or mortgage. With a term loan, you borrow a lump sum of capital upfront for a specific purpose. You repay the loan, with interest, over a set period of time with fixed, equal payments.

Term loans are well-suited for distinct use cases, such as business renovations or expansions. Some loans, like equipment financing or commercial real estate loans, are designed to facilitate specific business purchases.

SBA loans

SBA loans are small-business loans issued by participating lenders, typically banks and credit unions, and partially guaranteed by the U.S. Small Business Administration. The partial government guarantee reduces the risk for lenders and incentivizes them to work with small businesses.

There are several types of SBA loans, but in general, these loans are structured as term loans. The SBA sets guidelines for lenders regarding maximum loan amounts, repayment terms and interest rates.

SBA loans can be a good option for a variety of purposes, including working capital needs, business expansions and equipment purchases.

Business lines of credit

A business line of credit gives you access to a set amount of funds that you can draw from as needed. You only pay interest on the funds you draw, and in most cases, once you’ve paid back what you’ve borrowed, the credit line resets to the original limit.

Business lines of credit are one of the most flexible forms of debt financing — making them suitable for managing cash flow gaps and covering operating expenses, such as purchasing inventory or paying employees.

» MORE: Best working capital loans for small businesses

Business credit cards

Business credit cards operate similarly to business lines of credit. With a business credit card, you have access to a set amount of funds that you can pull from to make purchases. You’ll only start accruing interest on your balance, however, if you don’t pay your bill in full every month.

Business credit cards are a good way to finance every day or short-term expenses — especially since most cards offer rewards programs. These programs give you the ability to collect cash back, travel miles or bonus points for spending on your card.

Invoice financing and invoice factoring

Invoice financing and invoice factoring both allow you to access capital using your unpaid invoices. Invoice financing involves borrowing money from a lender (in the form of a loan or line of credit) against your outstanding invoices, whereas invoice factoring refers to selling your invoices to a factoring company at a discount.

Although these two types of debt financing have their differences, both are well-suited for business-to-business companies that have cash flow issues due to unpaid customer invoices.

Merchant cash advance

With a merchant cash advance (MCA) a company gives you a lump sum of capital upfront that you repay using a percentage of your debit and credit card sales, plus a fee. The MCA company typically deducts a daily or weekly percentage of your sales until the advance is repaid in full.

Although MCAs can be used to cover cash flow gaps and short-term expenses, they are one the most expensive forms of debt financing — with annual percentage rates that can reach as high as 350%. You should consider all other financing options before turning to a merchant cash advance.

» MORE: Best merchant cash advance companies

Advantages of debt financing

  • Maintain control of your business. Debt financing allows you to maintain complete control of your business, unlike equity financing. Whereas an investor receives an equity position in your business, a lender has no part in running your company.

  • Tax-deductible interest payments. In most cases, the interest payments on your debt financing will be tax deductible. This interest tax deduction is generally available as long as you’re borrowing money from an actual lender (and not friends or family) and using it for business purposes. Other loan costs, such as origination fees, can also be tax-deductible.

  • Easier to plan for the future. With debt financing, you can access capital relatively quickly and invest it in your business’s growth. And because you know how much you’ll need to repay every month, it’s easier to budget and plan for your company’s future.

  • Build business credit. Making timely payments on your debt financing can help establish and build your business credit. Developing a strong business credit history can help you qualify for loans with the most competitive interest rates and repayment terms in the future.

Disadvantages of debt financing

  • Can risk assets or credit history. Taking on debt can be risky for your business and personal finances. To get financing, you may have to put up your business assets as collateral or sign a personal guarantee. If you default on the loan, the lender can seize your business assets — or in the case of a personal guarantee, your personal assets — to recoup their losses. Late or missed payments could negatively impact your credit history, making it more difficult to qualify for financing in the future.

  • Can be a financial strain on the business. Debt can make it difficult to manage your business finances. You’ll need to make consistent payments on your loan, regardless of your revenue, which can be particularly taxing on seasonal businesses or those with inconsistent cash flow. Some businesses may also find it more challenging to try and grow operations while managing and repaying debt.

  • Can be difficult to qualify. Although debt financing is often easier to access than equity financing, it can be difficult to get options, like bank loans, that offer the most competitive terms and business loan rates. To get a bank loan, for example, you’ll typically need excellent credit, several years in business and strong finances. You may also have to put up collateral. Newer businesses and those with fair or bad credit may have a harder time accessing affordable debt financing.

How to choose debt financing for your business

If you’re thinking about financing your business with debt, consider the following factors to find the right option for your needs:

  • Why you need funding for your business.

  • How much capital you need.

  • Your business’s qualifications (e.g., personal credit score, time in business, annual revenue).

  • How fast you need access to funding.

  • How much debt you can afford.

Alternatives to debt financing

If debt financing isn’t the right fit for your business, there are a few other options to consider when you need funding for your business.

  • Equity financing. As previously discussed, equity financing is when you receive money from an investor in exchange for an amount of ownership in your business. In this case, you don’t take on debt, but you are no longer the sole owner of your operation. Learn more about the difference between equity and debt financing.

  • Business grants. Offered by federal, state and local government agencies as well as private organizations, grants don’t involve taking on debt, but winning one can be challenging because the competition is often stiff.

  • Crowdfunding. Using online sites such as Kickstarter and Indiegogo can allow you to solicit funds for your business without taking on additional debt, if you set up a rewards- or equity-based program.

Frequently asked questions

What’s the difference between debt financing and equity financing?

Debt financing is when you borrow money from a lender and repay it with interest. Equity financing involves raising money from investors by selling equity, or partial ownership, in your company.

What are examples of debt financing?

Examples of debt financing include traditional bank loans, SBA loans, lines of credit, credit cards, equipment loans, real estate loans, peer-to-peer loans, personal loans and loans from family and friends.

Is debt financing a loan?

Debt financing is when you borrow money to fund your business — and pay it back, with interest, over time. Loans are one of the most common types of debt financing.

A version of this article originally appeared on Fundera, a subsidiary of NerdWallet.

I have extensive expertise in the field of business finance and debt financing. Over the years, I've worked closely with businesses of various sizes, helping them navigate the complexities of securing funds through debt financing. My knowledge is not only theoretical but is backed by practical experience in assisting companies with their financial strategies.

Now, let's delve into the concepts mentioned in the article:

Debt Financing Overview:

Debt financing is a method of raising capital by borrowing money, which needs to be repaid along with interest by a specified future date. It stands in contrast to equity financing, where partial ownership of the company is sold to raise capital.

Types of Debt Financing:

  1. Business Term Loans:

    • Lump sum borrowed upfront.
    • Repaid with interest over a fixed period.
    • Suited for specific purposes like renovations or expansions.
  2. SBA Loans (Small Business Administration):

    • Small-business loans issued by participating lenders.
    • Partially guaranteed by the U.S. Small Business Administration.
    • Structured as term loans with set guidelines.
  3. Business Lines of Credit:

    • Access to a set amount of funds.
    • Pay interest only on the drawn funds.
    • Flexible for managing cash flow gaps.
  4. Business Credit Cards:

    • Similar to lines of credit.
    • Access to funds with interest if not paid in full monthly.
    • Often used for everyday or short-term expenses.
  5. Invoice Financing and Invoice Factoring:

    • Using unpaid invoices to access capital.
    • Financing involves borrowing against invoices, while factoring involves selling them at a discount.
  6. Merchant Cash Advance (MCA):

    • Lump sum upfront repaid as a percentage of debit/credit card sales.
    • High-cost financing, with APRs reaching as high as 350%.

Advantages of Debt Financing:

  • Maintain Control: Unlike equity financing, you retain complete control of your business.
  • Tax-Deductible Interest Payments: Interest payments are often tax-deductible.
  • Easier to Plan: Access capital quickly, making it easier to budget and plan for the future.
  • Build Business Credit: Timely payments help establish and build business credit.

Disadvantages of Debt Financing:

  • Risk to Assets or Credit History: Defaulting can lead to seizing of business or personal assets.
  • Financial Strain: Consistent payments may strain business finances, especially for seasonal businesses.
  • Qualification Challenges: It can be difficult to qualify, especially for businesses with fair or bad credit.

Choosing Debt Financing:

Consider factors such as:

  • Why you need funding.
  • Amount needed.
  • Business qualifications (credit score, time in business).
  • Speed of funding access.
  • Affordability.

Alternatives to Debt Financing:

  • Equity Financing: Getting money from investors in exchange for ownership.
  • Business Grants: Non-debt funding offered by government or private organizations.
  • Crowdfunding: Online platforms for funds without incurring debt.

FAQs:

  • Difference Between Debt Financing and Equity Financing: Debt involves borrowing, while equity is raising money by selling ownership.
  • Examples of Debt Financing: Bank loans, SBA loans, credit cards, etc.
  • Is Debt Financing a Loan?: Yes, it involves borrowing money and repaying it over time.

This comprehensive understanding should provide a solid foundation for anyone looking to explore debt financing for their business.

Debt Financing: How It Works, Types, Pros & Cons - NerdWallet (2024)

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