If you need working capital for your small business over a period of three years or less, a short-term business loan could be right for you. Short-term loans help businesses acquire needed equipment, hire new staff and address cash flow challenges. Here is what defines a short-term loan, how they work and the pros and cons.
How Short-Term Loans Work
Short-term loans are available principally from banks and online lenders. These loans generally are easier to apply for than long-term loans and it can take less time to obtain approval. However, they also have higher interest rates and larger monthly payments and may include prepayment penalties.
Short-term business loans are generally for periods of three years or less, with one year being a common term. Since lenders will be handing over borrowed sums for shorter periods of time before it is paid back, short-term loans are considered less risky than longer-term financing. Because of that, applicants for a short-term loan are also more likely to be approved.
Short-Term Loan Uses
Short-term loans can fulfill a wide variety of needs to help businesses grow sales and profits. Equipment purchases are one popular use. Many short-term borrowers are also using the funds to acquire inventory. Short-term loans can help pay for preparations for an upcoming busy season, or to expand by hiring extra staff. Businesses may also use the proceeds from short-term loans to fund renovations or expansions.
In general, businesses match the form of financing to the length of time the money will be needed. That is, a short-term project suggests a short-term loan. Short-term loans are not typically used to buy real estate, construct a new building, acquire another business or similar major, long-term project.
Applying for A Short-Term Loan
Before applying for a short-term loan, borrowers should first determine whether a short-term loan is a good fit. In addition to the length of time the money will needed, the size of the monthly payments and cost of the loan are considerations.
Next, borrowers can gather the documentation likely to be needed. This will often include bank statements, tax returns, financial statements, copies of the business plan, articles of incorporation or partnership agreements and licenses required to operate.
Banks can be good sources of short-term loans for businesses. This is especially true if the business has a pre-existing relationship with the bank, such as through a checking account or business credit card. Online lenders are also often used by businesses seeking short-term financing. The previous relationship may be less important to an online lender than the business credit score and the number of years the business has been operating.
Short-Term Loan Pros and Cons
Speed is a significant advantage of a short-term loan compared to many other forms of financing. The process of applying for a short-term loan at a bank or other provider is generally simpler than for longer-term financing. Less information is required and it takes less time and attention to fill out the application. Also, getting a short-term loan approved and receiving the funds can take significantly less time.
A business with a credit history that isn’t long or strong enough to qualify for a long-term loan can still hope to be approved for a short-term loan. Because lenders can expect faster repayment, they are more willing to make short-term loans to borrowers without stellar credit scores.
Lower overall borrowing cost is another important plus short-term loans have compared to other loans. Because the money is being loaned out for a shorter period, the loan will incur lower total interest even at higher interest rates. Businesses analyzing the purchase of a new machine or other proposition generally consider financing cost as a key part of the decision. When a short-term loan is used to pay for something, the acquisition may be easier to justify.
Balancing the advantages of short-term loans are the prospects of paying a higher annual percentage rate. Short-term loans typically carry interest rates of 10% and up. Also, because the principal is being paid back relatively sooner, the total monthly payment can be significantly higher than a longer-term loan for the same amount of money. Extra care to make sure the business’s cash flow can support the larger monthly payment of a short-term loan may be required.
The Bottom Line
Short-term loans help businesses pay for equipment, acquire inventory, manage cash flow and fill other short-term needs. Their higher interest rates and bigger monthly payments, compared to longer-term loans, are compensated for by simpler, faster application processes, greater likelihood of approval and lower overall borrowing costs. Business owners are advised to carefully calculate whether the expected revenue bump from using short-term loan funds will actually be enough to make the payments.
Tips for Business Owners
- Consider working with an experienced financial advisor if you are thinking about taking out a short-term business loan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Business owners can increase their chances of being approved by improving their credit scores before applying for a short-term loan. Making use of other short-term credit such as a business credit card and making required payments on time and in full is an effective way to boost a business credit score.
Photo credit: ©iStock.com/kate_sept2004, ©iStock.com/laflor, ©iStock.com/Piotrekswat