What is Debt Financing?
Many of us are familiar with loans, whether we’ve borrowed money for a mortgage or college tuition. Debt financing a business is much the same. The borrower accepts funds from an outside source and promises to repay the principal plus interest, which represents the “cost” of the money you initially borrowed.
Borrowers will then make monthly payments toward both interest and principal and put up some assets for collateral as reassurance to the lender. Collateral can include inventory, real estate, accounts receivable, insurance policies, or equipment, which will be used as repayment in the event the borrower defaults on the loan.
The following types of debt financing are the most common:
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- Traditional bank loans. While often difficult to obtain, these loans generally have more favorable interest rates than loans from alternative lenders.
- SBA loans. The federal Small Business Administration is a popular choice for business owners. The SBA offers loans through banking partners with lower interest rates and longer terms, but there are stricter requirements for approval.
- Merchant cash advances. This form of debt financing is a loan from an alternative lender that is repaid from a portion of your credit and debit card sales. Note that merchant cash advances have notoriously high annual percentage rates (APRs).
- Lines of credit. Business lines of credit provide you a lump sum of money, but you only draw on that money when you need some of it. You only pay interest on what you use, and you’re unlikely to encounter the collateral requirements of other debt financing types.
- Business credit cards. Business credit cards work just like your personal credit cards, but they may have features that serve businesses better – such as spending rewards that business credit lines lack.