Is Using a Loan For Overdraft Protection a Good Idea?
Cash-heavy businesses face unique financial challenges. If you need cash to pay bills, vendors, and suppliers, but your customers’ payments are delayed, you may not have the cash in your account when you need it to pay bills. Lengthy time to pay isn’t always a sign of deadbeat customers—in many industries, 60- or even 90-day payment cycles are common. However, that’s small comfort for the entrepreneur whose checks are bouncing.
Sure, you can use overdraft protection to cover these shortfalls, but overdraft fees can quickly start to add up. Seeking a better and more cost-effective way to handle the situation without racking up non-sufficient funds fees (NSFs), some small businesses take out business loans in order to put an extra cushion in their bank accounts. Is using a business loan as overdraft protection right for you?
A short-term loan can definitely enable you to pad your bank account enough to eliminate most NSF fees, and get your cash flow under control. On the plus side, short-term business loans generally require minimal paperwork and give you rapid access to the funds, so you can put them right into your bank account to provide the overdraft protection you seek. And since (as the name implies) short-term loans are paid off in a shorter time frame than longer-term loans—usually six months to a year—you won’t have the debt on your books for long.
On the downside, however, short-term loans have higher interest rates than longer-term loans, and may require putting up some collateral to obtain the money. And even though the loan is for a shorter period, you will still be tying up your credit, which can make it hard to apply for other loans should you need them.
Before applying for a short-term loan to provide overdraft protection, consider:
- The payments and interest rate. You’ll typically pay off a short-term loan with daily payments withdrawn automatically from your bank account. So be aware that as you are adding a cushion to your bank account, that cushion will also be withdrawn to pay itself off—plus interest. Your cash flow needs to be adequate to pay off the loan, or you could find yourself in worse shape than you started with loan payments plus NSFs.
- The effect on your business credit. Continually bouncing checks and/or tapping into your overdraft protection doesn’t create a good image of your business’s creditworthiness. The cost of obtaining and paying off a loan may be worth the boost to your cash flow and resulting better credit profile. Plus, paying off the loan on time will improve your business and personal credit score further.
- Your financial projections. Carefully assess whether you may need additional financing during the period of the short-term loan and, if so, make sure you don’t tie up so much credit that you can’t get the additional capital you seek.
- Your financial history. Do your homework to make sure you are getting the right loan for you. Go back over the past year’s financials and see how much you are spending each month in NSFs. If the interest rate on the business loan adds up to less than you’re already spending on overdraft protection fees, getting a business loan would definitely save you money.
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