Merchant Cash Advance Loans vs Business Loans – Pros and Cons
Merchant cash advance loans and traditional business loans are two options for increasing cash flow. Whether your goal is building up inventory, launching an advertising campaign or investing in new equipment to help operations run more efficiently, finding working capital is a major challenge for most business owners. Two options for increasing cash flow are traditional business loans and contemporary merchant cash advances. While both of these popular methods provide an upfront influx of cash to cover business expenses, there are key differences in approval, distribution and payment terms. Each loan type also has distinct advantages and flaws depending on your business model and strength of revenue.
The Benefits of Business Loans
Applying for a traditional business loan is the first pathway business owners typically try to pursue. These trustworthy lines of credit are issued by banks and are paid out as either a lump sum or deposited into an account that you draw from when the money is needed. This funding option is so attractive because it generally offers the lowest interest rates and fees. The 7a loan issued by the Small Business Administration (SBA) currently has rates set between 5.75 percent and 8.25 percent.
Another advantage to taking out a business loan is the fixed monthly payment, which is based on a combination of the loan amount, interest rate and repayment period. This allows you to accurately budget for the payment and adjust your customer pricing accordingly. You can slash interest costs by repaying the loan sooner than the terms. Since business loans are reported to the credit bureaus, you’ll build business credit as you increase business capital.
Business Loan Drawbacks
Unfortunately, qualifying for a business loan is a difficult task, especially for startups and sole proprietors. Most programs require at least two years of operating history, consistent revenue above $50,000 and a good personal FICO credit rating over 680.
Along with strict eligibility requirements and lengthy approval processes, these loans are designed to support long-term and significant expansion efforts. The SBA reports that the average amount issued for its 7a loan program was $371,628 in 2015. You must prove that you can cover the full monthly payment, which can be more than a mortgage, and you will still likely have to put up something valuable as collateral.
Business loans also come with steep fees that you pay upfront. The typical 4 percent origination fee is usually taken from the loan, so you do not receive the full amount that you apply for. You will also need to come up with the cash to pay the guarantee fee, a charge assessed by the SBA to cover the loan in case you default.
Advantages of Merchant Cash Advances
Limited approvals for business loans with favorable terms are pushing more entrepreneurs to explore merchant cash advances as a viable funding option. A recent study conducted by the Federal Reserve Bank of New York found that roughly 7 percent of businesses have agreed to take a cash advance that is paid back over time with future credit card sales. Most are small operations with 10 percent of microbusinesses generating less than $100,000 in annual revenue tapping this short-term financing opportunity.
Most loans carry repayment terms of six months to two years and generally have more flexible eligibility conditions even if you have a damaged credit history. Since the lending company takes a cut of every credit card transaction, you’ll need a strong history of sales. This fee varies widely across the industry, but you can expect to pay 5 percent to 20 percent depending on the strength of your business and the amount of the cash advance. There is no fixed payment, so you’ll pay more when business is booming and can breathe easier when seasonal sales slow down. There is no collateral required and approval is usually issued quickly.
Merchant Cash Advance Considerations
The biggest drawback of merchant cash advances is that you are borrowing against your future sales. This not only cuts into your profits but also means that you pay more as business grows. When cash is flowing, you could be putting out more in fees than you are bringing in for profit. Although you might pay the loan off sooner, you don’t actually save any money since the steep setup fees are paid at the beginning of the loan. These loans are not currently regulated by state and federal laws and do not help businesses build a credit history.
Visit the Personal Money Store to explore more options for accessing cash advances and tapping short-term installment loans.