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Short-term loans, often called cash flow loans, a relatively new offering in alternative financing, are quickly becoming one of the most popular alternative products available. Here’s a closer look at this financing vehicle.
Traditional business loans are typically based on a company’s assets, such as equipment or real estate, which are pledged as collateral for the loan. A cash flow loan, in contrast, is made based on the borrowing company’s expected future cash flow. Typically, cash flow loans vary from as low as $5,000 up to $250,000; repayment terms range from six to 18 months.
The application process is much shorter than for a traditional bank loan. The lender will want to see your cash flow history and projections, and will look at a variety of factors, including your customer base, average daily sales and average sales amount, and your personal credit rating, then make a decision in a matter of days or even hours.
In most cases, repayment is directly debited from your business bank account daily. Basically, as you make money, the lender receives a percentage of that money until the loan is paid off—so the repayment can vary day to day. Some cash flow loans have a more traditional repayment model where you pay a set amount over a specific time period. In this situation, you will always pay the same payment amount.
Cash flow loans are typically used to provide working capital. For example, you might use loan proceeds to buy inventory, purchase materials or cover payroll.
Businesses that are highly seasonal or tend to have predictable, yet dramatic ups and downs can benefit from cash flow loans. These types of loans are also popular with businesses that make a large amount of small-dollar sales.
In addition, cash flow loans can work well for businesses that don’t have outstanding credit ratings. Often, a business owner with a credit score as low as 500 can obtain a cash flow loan, provided the business has strong projected future cash flow.
Last, but not least, you’ll probably need a few years in business to qualify for a cash flow loan, since past cash flow is a consideration for lenders.
There are some important issues to understand before you apply for a cash flow loan.
Rates: Since cash flow loans aren’t collateralized by assets, they are riskier for lenders than collateral-backed loans. As a result, they are more expensive than traditional bank loans. Interest rates typically start at about 15 percent. Generally, the shorter the loan, the higher the interest rate.
Costs: In addition to interest rates, ask exactly what fees you will be charged for a cash flow loan. These can include loan origination fees, late fees, service fees, prepayment penalties and fees for insufficient funds.
Guarantees: Even though you don’t have to put up collateral for a cash flow loan, the lender may require you to sign a personal guarantee. This means that if your business can’t pay back the loan, you, personally, will do so. Make sure you’re comfortable doing this.
Repayments: Daily loan repayments can leave your cash flow in worse shape than it was if you don’t maintain sufficient funds in your business bank account to cover them, as fees can quickly add up. Make sure you have a “cushion” to cover loan repayments, and stay on top of your cash flow daily to monitor emerging problems.
Problem customers: It’s important to be confident in your future cash flow before applying for this type of loan. If you have issues with nonpaying or late-paying customers, cash flow financing probably isn’t your best option.
As with any type of small business loan, making a cash flow loan work for you requires fully understanding your repayment responsibilities, accurately forecasting financial projections, and diligently repaying the loan so your obligation remains under control. If you can do all this, a cash flow loan could be your ideal short-term financing solution.