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When Small-Business Loans Can Become an Addiction

Dec. 17, 2015
Small Business
Are You Addicted to Small-Business Loans?
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Small-business loans are so easy to come by nowadays that some entrepreneurs end up borrowing over and over again.

That’s when the borrowing can turn into something akin to an addiction, pushing small-business owners into a vicious debt trap.

“They’re stuck on a treadmill of needing it over and over again,” Molly Otter, chief investment officer at Lighter Capital, tells NerdWallet. “They don’t realize how expensive the loan is. They haven’t done the math. They don’t understand the cost. … It takes time for that to sink in.”

Entrepreneurs now find more options to finance their small businesses, but some of them also become vulnerable to making really bad financing choices, experts and lenders say.

“It’s a serious problem,” Sam Hodges, co-founder of Funding Circle, tells NerdWallet. “The root of the problem is the whole set of very high-rate, very opaque lenders.”

Quick access to capital, at a price

More alternative lenders are offering small-business owners quick and easy access to loans and financing, but many of these products are based on extremely high interest rates.

One example is the merchant cash advance, in which a small business sells a portion of its credit card sales in exchange for a quick cash infusion from the lender. It’s an attractive option for small-business owners needing quick access to financing, but it’s expensive money, with an effective annual percentage rate that could exceed 300%.

(Compare that with a traditional U.S. Small Business Administration loan, which is typically based on a prime rate plus an additional markup rate, known as the spread, of 2.25% to 2.75%. So at the current prime rate of 3.5%, the interest would range from 5.75% to 6.25%.)

“It might be access to capital that’s quick and easy. But it doesn’t get them anywhere. It’s like eating empty calories.”

— Caitlin McShane, Opportunity Fund

By going the quick-and-easy but high-cost route, some small-business owners end up with “an insurmountable debt burden,” Hodges says.

Craig Everett, professor of finance at the Pepperdine University Graziadio School of Business and Management, calls merchant cash advances “generally a really bad idea for a small business unless it is the last resort.”

“This type of financing can become addictive and will ultimately bleed a small business dry, so it should never be used for working capital purposes,” he tells NerdWallet.

Repeat financing: When one loan isn’t enough

Yet some small-business owners do use merchant cash advances to make payroll or for other operating expenses.

“They’re either desperate or they’re unsophisticated,” says Everett, who has a doctorate in finance from Purdue University. After taking on this type of financing, “they’re probably in the same bind when that first loan comes due. Unless something fundamental changes in their business, they’re probably going to do it again.”

Caitlin McShane, marketing and communications director at Opportunity Fund, says the nonprofit lender has dealt with small-business owners who began with a $20,000 debt that eventually ballooned to $100,000.

“It happens very quickly with repeat financing,” she says. “They go to the same lender over and over again.”

It could involve a small-business owner who takes on a short-term loan for what’s supposed to be a one-time business need, such as an expansion. “You don’t notice that your cash flow is suffocating, and you take a second loan,” she says. “You’re in over your head before you appreciate what’s happened.”

“It might be access to capital that’s quick and easy. But it doesn’t get them anywhere. It’s like eating empty calories.”

Tips to help avoid the debt cycle

McShane shares three important tips to keep from falling into a small-business loans debt trap:

1. Be wary of loan offers that sound too good to be true.

Some lenders tout the speed with which you could get a small-business loan or the payment scheme that’s based on your company’s sales. McShane says small-business owners should carefully consider offers that sound too good to be true and that could lead to enormous debt.

2. Don’t be swayed by marketing spin.

When it comes to some alternative lenders, McShane says, “the marketing tactics are strong, and they come in hot and heavy.” Some lenders, she warns, “aren’t looking at the long-term success of the business.”

Small-business owners should take the time to shop around and ask questions about loan products. “It’s worth the extra hour or two to find the right fit,” McShane says. “The cash might not come as quickly, and you might have to wait a couple of days, but it’s worth the wait.”

3. Be alert to signs that you’re already in trouble.

There are rare instances when it might make sense to take out a merchant cash advance for a short-term business need. In that case, you must “recognize the signs that you’re already in trouble,” McShane says. And the best way to do this is to constantly check your cash flow, or the way money moves in and out of your business operation.

“You’d want to do your own cash flow projections frequently,” she says. “So that if turns out that four months from now is when you run out of cash, you’ll know before it happens.”

To get more information about funding options and compare them for your small business, visit NerdWallet’s best business loans page. For free, personalized answers to questions about financing your business, visit the Small Business section of NerdWallet’s Ask an Advisor page.

The post was updated to reflect the new prime rate as of December 2015. It was originally published July 10, 2015.

Benjamin Pimentel is a staff writer at NerdWallet, a personal finance website. Email: [email protected]. Twitter: @benpimentel.

Image via iStock.