If you’re a small business owner struggling to make payments on credit cards and loans you might have been wondering if consolidating your debt would be a good idea. Debt consolidation companies often target those with high balances, sending letters and calling with promises to lower your monthly payments and save you money.
But do these companies really do what they promise, and can they help your business? Here’s everything you should know before applying to take out a debt consolidation loan.
What is Debt Consolidation?
During the start-up or growth stages of a small business many small business owners take on debt. Because you need capital to grow, you may open a small business credit card or a line of credit, or take out a short-term loan. After a while you may find yourself with multiple loan payments to juggle every month.
Debt consolidation combines all of your debt into one loan. Instead of owing money to multiple lenders, you owe to just one company and only have one monthly payment.
What are the Pros and Cons of Debt Consolidation?
There are many pros to debt consolidation.
If you struggle remembering to make all your payments, now you only have one payment to worry about. And you can set up auto-withdrawals from your checking account and forget about it. You can pay off higher interest-rate debt with your consolidation loan and save money on interest and other fees. Because less of your monthly payment goes to paying interest, you can pay down the principal balances faster.
The cons of debt consolidation first relate to your spending habits. It will not solve cash flow problems if your business is spending more than it makes in revenue. If you consolidate and pay off debt and then immediately charge up balances on a business credit card you could worsen your financial situation. And you should be absolutely sure that the debt consolidation will save you money and hassle overall.
Another con to debt consolidation is that it often extends the debt repayment term. If you’re only a few months or a year away from paying off a loan but you consolidate it with other debt you could add another two to three years to your repayment period. An extended repayment term could lead to a higher cost of capital overall.
Variable or Fixed Interest Rate
One of the reasons that many small business owners look into debt consolidation is to convert variable rate debt into fixed rate debt. If you have a loan or credit card that has a variable rate, typically based upon Prime or LIBOR, your monthly payment can fluctuate. This can make budgeting difficult.
When you consolidate debt into a fixed-rate debt consolidation loan your monthly payment won’t fluctuate. It makes budgeting and planning to pay off the loan’s principal easier. When you’re shopping around for a debt consolidation loan make sure that your lender is offering a fixed-rate product.
If you consolidate debt into a variable rate product, such as another credit card with a lower interest rate, you could run into trouble. If Prime rises and you’re then paying more interest on the loan product you used to consolidate you could end up paying more interest and fees in the long run.
Simple Interest Rate vs. APR
Don’t be fooled by a simple interest rate that’s lower than your current interest rate, always ask for the APR. A simple interest rate is the pure interest rate you’ll pay on your loan’s capital. If a bank advertises 5.5% on their website, read the fine print. This rate doesn’t include fees and other charges.
An Annual Percentage Rate, or APR, is more reflective of your true cost of capital. It blends together the simple interest rate, fees, and other costs to the loan to give you a more accurate representation of the loan’s true cost. If you’re talking to a lender about debt consolidation, ask them to provide you with the loan’s APR.
Often, once the origination fees, underwriting fees, and more are added into the cost of capital the loan consolidation may not save you as much money as you thought it would. Make sure to get a full and complete list of all fees before deciding on a loan. Being able to compare the APR between your current loan products and the debt consolidation product that you’re considering will help you make a wise decision.
Check for Prepayment Penalties
Before signing on the dotted line to consolidate your debt you should look into a few more things. Some lenders charge a prepayment penalty on their loan products. This is because when you pay off a loan early they’re not making as much money on it as they had planned. The prepayment penalty helps them make up some of that lost profit.
If you’re unsure if existing debtors will charge you a prepayment penalty call and ask before arranging to pay off the loan early. If one exists, it could wipe out any cost savings from consolidating your debt.
Will it Impact your Ability to Obtain More Credit?
When putting together a business plan you might have planned for a debt consolidation and then to take out another loan for a business expansion.
Banks look at your leverage when deciding whether or not to lend, and it also impacts your credit score. Leverage is the amount of your business that is financed by debt. If you take out a new form of credit to consolidate your debt, for example a credit card that’s interest-free for a year, and immediately close all other forms of credit it could actually hurt your credit score.
A component of your credit score is the ratio between your open lines of credit and the amount of capital you’ve borrowed. The higher this ratio creeps, the more it negatively impacts your score. For example, if you have total credit available of $50,000 and have borrowed $35,000 you’re using 70% of your available credit. This will negatively impact your score.
How does debt consolidation come into play? Let’s say you have a credit card, a loan, and a line of credit all open with available credit of $50,000 and have taken out $25,000 on all of them combined. Your current credit utilization is 50%.
Then you decide to consolidate and move 100% of that debt to one credit card with a limit of $35,000. You close all other forms of credit. Your credit utilization ratio is now 71%, which looks much worse. Banks may not be willing to grant you any more capital and your credit score could take a hit.
In this example, you’d be better off consolidating but also keeping the other forms of credit open. Your credit utilization would then be 29% and you’d have better odds of obtaining more capital, if needed.
Debt consolidation loans tempt many small business owners struggling with cash flow but they may not be the right choice for you. Try using a debt consolidation calculator to determine if consolidating your debt will truly help your business.
If the numbers are unclear, talk to your accountant or financial advisor about setting up a budget or other options to help you pay off debt faster. They can help you with some of the calculations and guide your debt consolidation decision.