Online lenders’ marketing pitch: sure, our interest rates are higher, but interest costs will be lower on a 6 month loan vs. a 5 year loan. In other words, they want you to compare short term vs. long term debt in “cents on the dollar” terms – how much in total interest and fees do you spend per dollar loaned.
It’s an appealing pitch to many businesses. For some it’s appropriate, but for others it’s not. What’s right for your business?
Let’s use the analogy of renting office space to make the idea of renting money a little more understandable.
Imagine that your business needs 1,500 square feet of office space. One landlord is offering you a three year lease at $20 per square foot. The other landlord is offering you a six month lease at $60 per square foot. Here’s the basic math:
- 1,500 sq feet X $20/square foot X 3 years = $90,000
- 1,500 sq feet X $60/square foot X .5 years = $45,000
Short Term vs. Long Term: Which is the better deal?
It depends on how long you need the space for, right?
It’s the same with money:
which deal is better depends on how long you need the money.
In business real estate there are many situations that might make a 6 month rental the right deal:
- you just need space six months a year for peak needs, then you can go back to being a virtual organization the other half of the year
- suddenly you landed a big client in a distant city and you need space to complete the six month contract
- you plan on leasing a much bigger space but it will take six months for that office to be built out
- you’re on track to be able to own office space – no landlord! – but it will take six months for the finances to come together
- you face lots of uncertainty in the business and you don’t want to commit to a three year lease.
If on the other hand you have a permanent need for at least 1,500 square feet, you would find yourself at the end of the six months lease saying: now what am I going to do?
When Short Term Is The Right Term
It’s the same with renting money. There are some situations in which a 6 month loan is the right deal:
- you have a seasonal business and need extra inventory or labor ahead of the peak, but you don’t need that working capital the rest of the year and you can pay it back
- suddenly you land a big short-term contract and you need to ramp up to make it happen, but you’ll be able to pay off a loan after it’s done and business is back to “normal”
- you are in equity fundraising mode, or applying for a big federal SBIR grant, but it will be six months before that cash is in the bank
- payments on a big profitable contract will be coming within six months that will allow you to have a financial cushion that can be re-invested in the business, including paying down debt
- you face lots of uncertainty in the business and you don’t want to commit to a personal guarantee on a three year loan
- You’ve done the research and you can’t get a three year loan, but a six month loan will generate positive cash flow and get you into a better financial situation.
When Long Term Means More Cash For You
On the other hand, if you have a long term or a permanent need for additional capital, you really should take the longer term loan.
- Your business is steadily growing, as are your working capital needs for accounts receivable or inventory, and it looks like those working capital needs will continue or even grow for the foreseeable future.
- You are buying equipment that will be useful for three or more years, and you’re likely to need even more equipment in the future.
- Your monthly cash flow varies enough that there is a risk of not being able to make every single, significantly higher payment on a short term higher-payment loan.
- That cash flow variation is even more significant weekly, and the six month loan requires weekly payments. Or your cash flow variation is pretty significant daily – Mondays and Tuesdays are slow sales days for you – and sometimes these loans require daily payments!
The Risk of Higher Monthly Payments
Missing even one payment by a few dollars or a few days can trigger fees and higher interest rates. That important detail may be buried in fine print.
Here are some numbers to help illustrate the risk of higher monthly payments associated with short term loans:
- 3 year, $20,000 loan at 10% interest means a repayment of $645.34 per month. The interest cost total over 3 years is $3,232.37.
- 6 month, $20,000 loan at 30% interest means a repayment of $3,631.00 per month or $830.58 per week (if compounded and paid weekly) – $1786 total interest if paid monthly, $1595.08 total interest if paid weekly.
Which one is a better deal for you?