Whether you’re just starting a business or moving a new product to market, it’s vital to keep your capital flowing. Many small business owners turn to loans to make that happen, and in recent years, a new kind of product has become popular for businesses that can’t qualify for longer funding—the short-term loan. Case in point: the amount of money that non-bank lenders provided for short-term loans doubled between 2012 and 2013, increasing from $1.5 billion to $3 billion.
Taking out a new short-term loan to refinance your existing short-term debt can be a bit scary, though. After all, you’re accumulating more debt with the potential for quite a bit more interest. But in certain situations, it’s a smart option for small business owners… The key is just to know when to use this strategy.
Here are some of the most relevant pros and cons you should consider before refinancing short-term debt with another short-term loan.
Refinancing Short-Term Debt: The Good
Let’s start off with the benefits:
1. Increase your Working Capital
Refinancing a short-term loan with another short-term loan doesn’t always have to be a “back to the wall” last resort. In some cases, it’ll make sense to pursue a new loan in order to help grow a business. Business owners might need an infusion of fresh working capital to invest in the company or to take advantage of a profitable, one-time only business opportunity.
The key here is telling the difference between opportunities that will actually move the needle from investments that may or may not pay off. If you’re borrowing more money for something that’s fairly low risk and could have a significant positive impact on the health of your business, additional short-term borrowing could be worth the cost.
2. Extend the Loan Term and Lower Your Daily Payment
There’s really only one constant in the realm of business: nothing is constant. Conditions are always changing, obstacles are always popping up—you know the drill. The loan terms that made sense for your business a year ago might not work as well for you today.
Refinancing your existing debt with a new short-term loan can extend your payment horizon, letting you adapt to business circumstances as they change. By extending the term of your small business loan, you could significantly lower your payments, freeing up cash to invest in other things.
Refinancing Short-Term Debt: The Bad
Now that we’ve covered some of the reasons why this loan strategy makes sense, let’s take a look at the dangers of borrowing more money to refinance existing short-term debt:
1. Paying Interest on Interest
The financial cost: probably the most serious drawback to pursuing a new short-term loan to refinance existing debt. Because you’ll typically pay back your existing loan balance and the interest attached as part of the new loan, you might wind up paying interest on interest.
Generally speaking, refinancing with a new short-term loan isn’t going to be the most cost-effective outcome.
2. Your Might Not be Able to Refinance With Another Lender
The more flexibility you have as a business owner, the better off you are. It’s always good to keep your options open so that you can adapt to emergencies or unforeseen circumstances. But if you decide to refinance short-term debt with another short-term loan, those options could become a bit narrower.
A new loan might prevent your existing balance from becoming low enough to qualify for service by another lender. While this might not be a problem for business owners who are happy with their existing lender, it does limit your ability to shop around for a more competitive deal.
3. Is it a Temporary Solution to a Bigger Problem?
Business owners on the verge of default or closure are often looking for any port in a storm. When your choices are to take out another loan or lose the business, then paying added interest doesn’t seem like much of a deal breaker.
Still, it’s important to take a good hard look at the state of your business and give yourself an honest appraisal. Going further into debt might be the best choice if that new debt serves as a bridge to something better. If you’re using a new loan as a form of “corporate triage,” though, you might want to reevaluate your position. If the loan is just a temporary fix for a deeper, more systemic problem, adding new debt might only prolong the issue.
Refinancing your existing short-term debt with a new short-term loan could make sense under certain conditions, though there are significant downsides you should be aware of. But if your business could grow by refinancing that short-term debt with a longer-term loan, that’s ideal—you’ll save money and stress with lower, less frequent payments. Either way, carefully consider the benefits and dangers of refinancing short-term debt with short-term debt before making the decision that’s best for your business.
Editor’s Note: This post was originally published on Fundera.com.
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