Many businesses take on debt when they're first getting started or when they're trying to grow. Others rely on loans when they're faced with obstacles like seasonal downturns or recessions. But, structuring business credit on an ad hoc basis can leave a business with several different types of outstanding debts, each with its own interest rate and terms.
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What is debt consolidation? How do business owners use it?
Debt consolidation is the process of combining several outstanding loans into one new loan. Business owners use debt consolidation to reduce their overall interest rate, extend loan terms, simplify their repayment schedule, or free up other forms of credit to finance ongoing business operations.
Debt consolidation options
There are many ways to consolidate business debt. Some lenders specialize in consolidation loans, but really, any loan that helps business owners reduce their number of outstanding debts achieves the goal of consolidation. Still, there are some types of financing that are generally better than others when it comes to consolidating debt.
Best loans for debt consolidation
|Loan type||Best for|
|Bank loan||Borrowers with great credit and reliable revenue|
|SBA loan||Low rates if you don’t have stellar credit|
|Fast funding to consolidate high-interest debts|
|Personal loan||Borrowers with strong personal credit and outside collateral|
|Line of credit||Getting regular access to credit on a revolving basis|
Not all of these loans work for all business owners. In other cases, loans may be available, but may not be ideal for your circumstances. So, the first thing to do is understand your options.
1. Bank loan
For businesses that have outstanding loans they want to consolidate, the first choice should be loans issued by commercial banks. A business term loan is the most common type of financing used for this purpose. The biggest advantage of using banks to consolidate debt is that they're simple: They offer simple loans with simple terms, simple underwriting, and simple rates and fees.
While bank loans offer a lot of advantages, they can be extremely difficult to get. Banks tend to look for established companies to lend to, so you should have an established banking relationship, strong credit and consistent business revenue if you decide to pursue this option. If you don't have great credit or your business is still getting started, these loans can be impossible to get.
2. SBA loan
A Small Business Administration (SBA) loan is issued by an SBA-approved lender and then partially guaranteed by the SBA. The SBA 7(a) program is the most common program used for consolidation purposes. The SBA stamp of approval offers many borrowers access to lower rates than they could otherwise get, and borrowers can usually qualify with lower credit scores than are required to get a conventional bank loan.
While an SBA loan can help you get a loan if you don't have great credit, the SBA is not designed to be your first choice. Instead, the SBA is a lender of last resort, so you shouldn't consider using one of its loan programs if you haven't already looked for financing elsewhere. You'll also need a strong business plan in order to qualify for an SBA loan, so make sure you have one ready before you apply.
3. Alternative lending
In addition to conventional lenders like banks and the SBA, there are also online lenders that offer private loans. A term loan is usually the best type of alternative loan for consolidating debt. These loans are usually very fast and easy to get – business owners can often get approved in as fast as 24 hours and have their loan funded within days.
The downside, though, is that alternative loans are typically expensive. In addition to high rates, most lenders require a business to have been operating for at least a year or two in order to qualify. Alternative loans are probably your best bet if you need financing quickly, but if you have other options, you should definitely explore those first.
4. Personal loan
Personal loans for business are great because you can get one using just your personal credit – you don't need to have a business credit score or a certain number of years in business in order to qualify. And, these loans are often available online and offer quick approval.
However, to get a loan, you may need to have income outside your business. The lender will underwrite your loan based on your personal finances and credit, so revenue derived from your business may not be considered in your application.
So, if you have outside income or collateral separate from your company, a personal loan can be a great way to consolidate your business debt. It may also be your best bet if your company is still in its first year or two of operations and you need fast funding, or if the debt you want to consolidate is composed of personal credit cards and other personal debts that you used to fund your business.
5. Line of credit
Lines of credit come in many forms. There are business lines of credit, home equity lines of credit (HELOCs), and even lines of credit available through the SBA. Using a line of credit, you get access to funds that you can tap as needed. You only pay interest on funds as you tap them, and payments are usually interest-only until the loan expires. Rates typically start around prime plus 2.0% but can go much higher.
One great thing about a line of credit is that once you pay back the money you've borrowed, you can tap it again. This makes a line of credit a great option if you need regular access to capital. If you just need capital upfront to pay off other debts, you can probably find lower rates with bank or SBA term loans.
How business debt consolidation works
The process of consolidating business debt isn’t always easy, but it's fairly straightforward. In order to consolidate debt, you need to take an inventory of your current debts. Then, you’ll need to find a lender and loan product, apply, get approved, and use the loan proceeds to pay off your current loans.
When you get a consolidation loan, you probably won't be able to borrow more than the total value of loans you’re trying to consolidate. In fact, you may need to come up with a down payment. Some lenders will also require credit scores of 700 or higher, while others (like SBA loans) can provide loans for borrowers with credit scores of 640 or higher.
Business owners also may not be able to consolidate if they've defaulted on any of their outstanding loans, if they have a recent bankruptcy, or if they haven't been in business for at least a year or two.
The 8 steps to consolidating business debt
To get a consolidation loan, there are some steps you’ll have to follow. A consolidation loan is just like any other loan and will require an application, underwriting and funding. The entire process, from start to finish, looks something like this:
- Take inventory all of your outstanding loans.
- Figure out your total payments each month and your effective interest rate (multiply each loan’s interest rate by the loan amount, then add together the results and divide by the total debt outstanding).
- Determine whether you can lower your overall cost of debt (if your effective interest rate is higher than 8% to 10%, for example).
- Find a lender who offers consolidation loans for your industry.
- Confirm that you qualify – that your debt-to-income ratio won't exceed the lender's limits after you pay off outstanding debts, for example.
- Apply for the loan and provide any supporting documents to facilitate underwriting.
- Close on your loan.
- Pay off other debts and start making payments on your new loan.
Items to gather before applying for a consolidation loan
Before you apply for a loan, it's a good idea to get your documents together. Debt consolidation loans are taken for a very specific purpose, and it's important for your lender to know upfront why you want the loan and how you'll use it. Otherwise, your loan application may be turned down because you already have debt outstanding.
So, what records do you need to have organized to get a consolidation loan? Here's what you'll need:
- Your business credit score
- Your personal credit score (at least do a free check to make sure your credit is in good shape)
- A balance sheet of your personal finances
- Personal tax returns for the last two years
- A business balance sheet and P&L
- Information on debt being consolidated
For each of the loans being consolidated, you should have the name of the lender, your balance, loan terms, interest rate, payment schedule, monthly payment amount, and any other relevant information. [Read related article: The Ultimate Guide on How to Get a Business Loan]
Business debt consolidation vs. refinancing
Refinancing is when a borrower takes out a new loan and uses the proceeds to pay off a previous loan. Usually, this is done to get a lower interest rate or extend the term of a loan for lower payments. This is different from debt consolidation in that refinancing is for a single loan, while debt consolidation involves setting up new financing in order to pay off numerous outstanding debts.
Most avenues for consolidating business debt involve refinancing. But, while refinancing is one way that people can consolidate business debt, it's not the only way – borrowers may be able to sell stock in their business and use the cash pay off debt, for example.
While not all refinancing options are designed for consolidation, getting a loan to consolidate business debt is a lot like refinancing in that it requires a loan application, underwriting (including a credit check), a closing, and so on.
A consolidation loan can also have similar effects on a business owner's credit as refinancing. There will still be a hard credit check, and the loan will still be added to your credit report as a new open credit account. And, if you fail to pay off all of your debts using the new consolidation loan, you can really hurt your credit score if your overall credit utilization rate rises or you miss any payments. [Read related article: What to Know Before You Refinance Your Business Loans]
Pros and cons of consolidating business debt
As with any loan, there are pros and cons to a business debt consolidation loan, so you'll want to carefully consider your options and consult with your accountant or another trusted advisor. Here are some points to consider before you decide business debt consolidation is the right course of action for your company.
- You can often lower your overall interest rate.
- You’ll get simplified repayment terms.
- There's no more juggling of loans.
- There are some firms that specialize in this.
- Loans can be difficult to get.
- Your overall interest rate may actually go up.
- You may end up paying more in total interest over the life of your loan.
- It can be difficult to get a loan without a down payment.
- It can take longer to pay off your debt.