Learn about what kind of risk you’re taking on when you borrow
Small business owners need capital to grow their businesses. And while Black-, Asian-, and Hispanic-owned businesses were more likely than white-owned businesses to apply for credit in 2021, they were much less likely to receive the funding they sought: 35% of white-owned businesses said they received all of the credit they requested, compared to 19% of Hispanic, 16% of Black-owned businesses, and 15% of Asian businessses.1
Small business owners
There are various reasons that financing applications might not be approved. This inequity means that if you’re a minority business owner, you’re more likely to turn to alternative financing or higher risk financing options to meet your funding needs. Higher-risk options tend to cost more, come with shorter repayment terms, and increase a borrower’s risk of late payments and default.
Regardless of what type of financing you are able to obtain, it’s important to understand the level of risk you are taking on. Consider the following financing options and their relative levels of risk.
Traditional business loans
Provided by banks and other financial institutions, traditional business loans typically have fixed interest rates, which means business owners can anticipate exactly how much they’ll need to pay over the life of the loan. The terms on a business loan depend on your credit, business finances, time in business, type of business, and other factors.2
Business lines of credit
A business line of credit is similar to a traditional loan, except that it provides an ongoing and reusable option to access capital up to a certain cap. Lines of credit lower risk by allowing you to borrow only what you need at any given time, reducing the amount you have to pay back over time. However, be aware that lines of credit often have variable interest rates, which rise and fall along with prevailing rates. In a rising rate environment, your loan will grow more expensive over time.
The U.S. Small Business Administration (SBA) offers a series of loan programs that are administered by partner lenders throughout the country, often targeting borrowers who are not well served by the traditional lending industry. SBA loans are among the lowest-risk borrowing options, as they come with low rates and may be accompanied by support, such as business advice or financial management help.
Short-term business loans
These bank loans are structured as typical installment loans, but on a short timeframe — usually three to 10 years. Short-term business loans often have higher interest rates than longer-term loans, which can make them more difficult to repay successfully.
Like a merchant cash advance, invoice factoring allows a lender to use revenue you haven’t yet collected as collateral for a loan. However, invoice factoring, which is most often available via alternative online lenders, is somewhat less risky than a merchant cash advance. That’s because the invoices are specific expected payments that can be collected upon. Invoice factoring can be a reasonable option for businesses with certain cash flow needs, such as slow payment from certain customers or seasonal ups and downs.
Venture capital (VC)
Venture capital investors generally do not require personal assets as collateral. Likewise, venture capitalists (VCs) typically don’t expect business owners to pay back their investments on a particular time schedule. Instead, VCs seek equity in the company and also may assume a decision-making role — potentially taking more ownership and decision-making power than the founder is comfortable giving up.
Using personal loans from a bank or credit union to fund a business is very risky: Inability to pay back a personal loan will damage your personal credit. If you must give a personal guarantee or put up collateral of a personal nature — for instance, you might take out a home equity loan or line of credit using your home as collateral — those assets can be foreclosed on if the business defaults.
Merchant cash advances
These loans, offered by alternative lenders that often operate online, treat your business’s future revenues as an asset to lend against. Advances are high risk because you are borrowing against money you don’t yet have; if you don’t bring in the predicted amount of revenue, you will be at risk of defaulting on the loan. Since these loans are considered high risk, they often have high interest rates and rigid repayment terms.
Personal credit cards
Credit cards often come with high interest rates, which can make repayment increasingly difficult over time. Using personal credit cards for business purposes — a common tactic for many small business owners, especially early in the life of the business — puts your personal credit at risk.
Like many small business owners, you may be reluctant to take on debt. But with a better understanding of your options and how each could help your business grow, you can feel more confident in getting the capital you need to reach your goals. The different types of financing are suitable for different purposes. For questions about what’s best for your business, make an appointment to talk to a banker.
1. Federal Reserve Banks, Small Business Credit Survey 2022 Report on Firms Owned by People of Color
2. Experian, What Is the Average Interest Rate on a Business Loan?