How do I choose a loan to consolidate my small business debts?

Sometimes borrowing is unavoidable for a business. Check out how to choose the right loan to consolidate those debts.

For small businesses, it’s not unusual to borrow money to smooth cash flow or cover unexpected costs. The trouble is, when all the bills are due, it can be tough to keep track of all the payments. With debt consolidation, all those bills are merged into a single, potentially cheaper payment.

Debt isn’t inherently bad. Most financing, after all, creates debt. It can save a company from going under in a pinch or make growth happen. Yet many small-business owners are still ashamed to admit they have debt.

They see debt as a bad thing, says Kristyn Squires, head of small business at KeyBank. Getting better cash flow, cheaper capital and managing that capital properly will help small businesses grow more quickly, she says. Look for opportunities to improve your capital flow by finding less expensive debt.

But not all loans are equal. Short-term loans with high interest rates can get a business out of a bind but can drag it down in the long run, and debt spread out over many loans can be difficult to track.

Business debt consolidation is similar to personal debt consolidation: If you have multiple payments, consolidating them makes it easier to keep track and potentially pay less. Once upon a time, your neighborhood bank was the only place to consolidate debt, but now it’s an option from a lot of sources.

The process is simple: Decide which debts to consolidate, get a loan, and use the funds to pay those debts. Then make one monthly payment instead of several.

Loan Options

There are lots of loan options for business debt consolidation, from SBA-backed loans through a bank to loans from online lenders.

Look to your own bank first. When you’re already in the door at your own bank, it’s a natural choice to apply for a loan. These aren’t the same high-tech loans available from mobile banks, but rates and terms can be competitive.

Getting a loan from a traditional bank is still a challenge, especially for small businesses. Small-business bank loans can be hard to come by since the recession of 2008-09, when big banks tightened their lending standards, leaving small firms out. They generally prefer established, high-growth businesses with excellent credit.

Smaller banks may be a better choice if you’re already a customer there, says Josh Knauer, adjunct professor at Carnegie Mellon and founder of JumpScale. Traditional banks also may require collateral.

The Small Business Administration is a federal agency that partners with banks and other lenders to offer several loan programs. Some of these programs can be used for equipment or to consolidate debt. Because the loans are federally guaranteed, lenders are more willing to make them.

Rates can be competitive with those of traditional banks and some programs come with ongoing support to help your business grow. You won’t always need to put up a large down payment, and in some cases you won’t need collateral.

The SBA offers several types of loans. The two most popular are the 7(a) and 504:

• The standard 7(a) loan can be had for up to $5 million. The SBA guarantees 85% of the loan if you borrow up to $150,000, or 75% if you borrow more. It can take 5 to 10 business days to fund.
• The 7(a) small loan is the little brother of the 7(a) - so it has a smaller maximum amount, $500,000. It’s the same 85%/75% guarantee. It has no collateral requirement up to $50,000. It can be funded in two to 10 business days.
• The SBA Express loan is like the 7(a) loan, but it moves faster - you could get initial approval in as little as 36 hours - and offers a smaller amount, $500,000. The SBA guarantees 50% of the loan, which you can use as either a term loan or revolving line of credit.
• The SBA’s 504 loan program provides small businesses with long-term fixed-rate financing, with the SBA covering 40%, a bank covering 50%, and the borrower 10%. It’s meant to finance fixed assets like growth or renovation, not consolidating debt.

Online and alternative lenders are companies, often online, that aren’t a traditional bank. After the Great Recession, when traditional bank loans were scarce, online and alternative lenders emerged, lending when traditional banks wouldn’t. Many now focus on small-business lending.

Several types of online lenders exist, including direct private lenders, marketplace lenders and crowdfunding platforms. These loans typically have higher rates than those from traditional banks or the SBA, but they’re also easier to qualify for.

Online products come in many shapes and sizes, from short-term loans to installment loans. An installment loan - where you receive a lump sum to repay on a schedule - is generally best to consolidate. These usually come with fixed rates, so you know exactly how much you’ll pay each month.

Shop Around to Find the Best Loan

Finding the right loan to consolidate business debt comes down to the interest rate, right? Not exactly. The interest rate can make a big difference on how much you spend, but it isn’t the only thing that matters. Weigh the loan’s terms and the lender carefully. It’s important to shop around to find the best loan for you.

Consolidating debt is tempting when there are so many payments to keep up with, but does it make sense for your cash flow and interest rates? Figure out why you want to consolidate before you shop around.

Is it more important to lower the rate? Or to make payments easier to track? Do you need the money yesterday, or can you wait a few days? Ask yourself these questions and consider how the answers affect your process for shopping.

Knowing your credit score and other finances gives you a baseline as you shop. Lenders usually have minimum credit score and time-in-business requirements to qualify. Knowing what these are ahead of time will keep you from wasting time applying for a loan that you can’t qualify for.

One of the ways consolidating works is by paying off existing loans. Before applying for a loan, review the terms on your current loans to see if there’s a penalty for prepaying. A small fee may be OK, or it might be a dealbreaker.

A lower rate is a great incentive to consolidate debt, but sometimes that means a longer repayment period that costs you more. Make sure you know how much you’re paying over the life of each loan by listing rates, fees, balances due and due dates. Some low-rate loans may not be worth the effort to consolidate.

On the other hand, if payments are unmanageable, it won’t matter how much you saved with the slightly lower rate. Missed payments can hurt your credit. If it makes it easier to keep track of payments and avoid missing payments, even a slightly higher rate can be worth it. Sometimes the rate is less important than the headache of keeping track of payments.

When you’re choosing which debts to consolidate, decide what you want to accomplish, then match it to your options. With a goal of freeing cash flow, only consolidating the shortest-term or biggest-payment debts can make sense. A goal of simplifying can require consolidating all debts.

The true cost of a loan is hard to tell from interest rates alone, because there are other fees and such that can eat into the cost of borrowing. An APR includes the interest rate and other fees - the total cost of borrowing. You can compare apples to apples by looking at how much each loan will cost you in interest and fees, over the life of each loan. Also, ask about prepayment penalties. Paying back the loan early could cost you more.

You’ll want your lender to be accessible, willing to work with you in terms of how you’ll pay back the loan. Maybe that means a bank or credit union where you’ll mail a check each month, maybe that means an online lender who lets you pay automatically. Those who love to go cashless will likely love online loans. Those who prefer the human touch would likely be better at a bank or credit union.

Don’t make yourself go with the first offer that comes your way. Estimate how much each offer costs you monthly and over the life of each loan. Compare like with like. You won’t know what kind of offers you’ll get until you shop around, so as a rule of thumb get at least three offers.

Get your documents in order so you don’t have to track them down once you find a lender. You may be asked for bank statements, tax returns, financial statements and a business plan, among other documents. The quicker you can submit, the quicker you can get the funds. Missing documents or slow submission means delay.

The Pros and Cons of Consolidating

Consolidating your debt can relieve cash flow, save you money and make managing your payments easier.

Merging multiple debts also often results in a lower interest rate. Welcome news for some business owners. For those whose businesses got hit hard by the COVID-19 pandemic, cutting costs was a matter of survival.

One of the biggest reasons to consolidate is to simplify your payments. When all your debts have different due dates and websites or payment portals, keeping track of when to pay what and how much can be a headache. Consolidating means all you have to do is write one check or make one payment to a single lender.

Freeing up cash flow means taking on a new loan to pay off existing debt. A lender may let you stretch a new loan’s terms, which means a lower monthly payment and cash in your pocket. Sometimes you just need free cash. Whether for an opportunity or equipment, a new loan might be a way to get it. However, longer term means more interest over the life of the loan.

Consolidating has plenty of benefits, but there are drawbacks too. Here are the three main ones to consider before consolidating.

Paying off your debts also means taking on a new loan, which will often come with a longer term. So while the monthly payment could be lower, you’ll pay more over the life of the loan. If the loan doesn’t boost revenue, or allow you to make money, think twice about digging yourself deeper into debt.

Want the best rates on a new loan? You’ll need excellent credit. Don’t fit in that category? Ask for the rates that apply to you. The best rates - the ones you see advertised - don’t apply to everyone. Your best deal is tied to your credit score. Buyer beware - the best deals go to those who don’t need them!

Consolidating is no magic wand to erase all debts. It doesn’t fix the thing that got you into debt. Ask yourself what’s got you here. Is it bad cash flow? Unplanned expenses? If you pay off old debts, but then run up new ones, the problem isn’t solved.

This is not a decision to take lightly. But in the right circumstances, with good credit and a business that needs a boost in the short term, it might be just the thing that helps your business grow and thrive.