What Is Debt Refinancing?
Debt refinancing is when you pay down your remaining debt from a loan with the proceeds of a new, better loan. Debt refinancing does involve paying interest on interest and could trigger prepayment penalties for your original debt. That said, it can also offer longer repayment terms, lower rates, and less frequent payments.
There are several reasons you may want to consider refinancing your small business loans. Perhaps, for example, the payments you’re making still primarily go toward the interest rather than the principal. Refinancing your business loan, also known as debt refinancing, can help you qualify for a longer-term loan with more affordable rates.
In this post, we’ll walk you through what debt refinancing is, why you might need it, and how it works. At Fundera, we’ve helped many small business owners refinance business debt, saving them thousands of dollars each month. As such, we’ve compiled a guide to all things debt refinancing to let you in on one of the most powerful money-saving tactics a business owner can have in their toolbox.
Let’s get started.
- How to refinance debt
- Business debt refinancing pros
- Business debt refinancing cons
- Business debt refinancing eligibility
3 Ways to Refinance Business Debt
Do any of the aforementioned benefits sound like they could be useful for your small business? If so, now is a good time to figure out which kind of debt refinancing you should start looking into.
Here are the three main types of refinancing out there:
1. Incremental Refinancing
This is a common, but useful and important, way to use debt refinancing.
Let’s say your business’s details and financials haven’t changed too much since you took out your last loan. Maybe it’s been a few months and you’ve put that extra capital to good use, growing your inventory a little or launching a new marketing campaign. In other words, it’s been business as usual, but you were still able to snag a better deal on a business loan when you applied for debt refinancing.
Whether in terms of more favorable rates, longer terms, or more capital, the refinancing loan you can qualify for is somehow a step up from your current debt.
This might not be a groundbreaking change. Maybe you’re moving from $40,000 to $60,000 in financing, for example, or from a loan term of 18 to 24 months, but you’re still expanding your possibilities for growth, building credit, and keeping the financing cycle going.
This kind of refinancing isn’t for everyone, and if you don’t need a second loan then you shouldn’t take one out. But if you’re looking to continue your business growth, refinancing your current debt with a better loan will help.
2. “Graduation” Debt Refinancing
On the other hand, maybe your business hit a certain milestone since your last business loan. If that’s the case, you might very well qualify for a whole new set of better loan options for debt refinancing.
These larger and more affordable loans, with longer terms and less frequent repayments, can change the way your business operates—in a big way. You can save money, breathe easier with a more flexible cash flow, worry less about more manageable payments, and use that extra cash to substantially develop your business.
Here are just a few standard milestones that could indicate your business might qualify for better financing:
- Reaching the five years in business mark. Fifty percent of newly created businesses fail within their first five years, so making it to five years proves to lenders that your business model is pretty sustainable. The more confident lenders are in your business, the better their loan offers will be.
- Making six figures in annual revenue. The more money your business takes in, the more lenders will expect it to continue taking in. From a lender’s point of view, a proven successful business is a better investment.
- Hitting a 700 personal credit score. Your personal credit score is very closely tied to both what loans you qualify for and how much they cost, and getting a 700 credit score or above could make a huge difference in the financing available to your business.
You should note that these aren’t hard-and-fast rules. Hitting one of these benchmarks won’t necessarily qualify you for a better loan, but they are common guidelines that a lot of lenders tend to follow. So if you’re able to, graduating from one loan into a substantially better product can make a big difference to your business.
Just imagine refinancing your relatively small and expensive short-term loan with a bigger, more affordable medium-term loan, and then refinancing that into a long-term, single-digit interest rate SBA loan. By making some smart choices and thinking seriously about your business financing, you’ve potentially moved from an 18-month loan of $40,000 with daily payments and 20% APR to a 10-year loan of $120,000 with monthly payments and 6% APR.
Of course, that’s just an example, but we’ve seen it happen plenty of times.
3. Debt Consolidation
Debt refinancing and debt consolidation are often used interchangeably, but that’s not quite correct. Debt consolidation is actually a kind of debt refinancing.
Debt consolidation loans help you take out one loan to pay off multiple smaller loans (as opposed to one smaller loan, as with the above examples). For example, say you’ve taken out several small loans over the course of a year to pay for some unforeseen expenses. Those payments add up.
With debt consolidation, you can roll up all those different daily payments into a larger weekly payment. In terms of how it can help your business, debt consolidation brings all the same advantages of normal debt financing: you’ll save money, get more capital, have longer to pay off your debt, and be able to spend more flexibly.
Plus, you get to establish a more regular payment schedule and bring together your various sources of business credit. You can worry less about forgetting to make a payment and hurting your credit score, too.
Examples of debt consolidation loans:
We’ve already alluded to why you might want to refinance business debt, but let’s take a look at the three most important reasons:
1. Debt Refinancing Can Offer Lower Rates
Taking out a second loan to pay off your first one might make sense if, say, that second loan comes with a lower interest rate.
All of a sudden, debt refinancing can make your business debt more affordable.
We’ll talk more about this later on, but depending on when you’re able to refinance business debt, you could be paying substantially less interest on the principal—which is the amount you borrowed from a lender. In other words, debt refinancing can lower your overall rate. You’re borrowing for less.
And there are especially expensive loan products—like merchant cash advances—that are great choices to refinance into more affordable kinds of debt. The option to refinance business debt gives you the chance to limit the damage that pricey short-term borrowing can do to your bank account or cash flow.
2. Debt Refinancing Can Offer Longer Terms
Another reason to take out a business debt consolidation loan is if that second loan comes with a longer term. In other words, you’ll have more time to pay off the money you borrowed (plus interest).
You might look for a longer term because your current loan’s payments are cutting into your cash flow, you want to lower each payment amount, or you want less frequent payments—like weekly or monthly instead of daily payments.
Regardless of the exact benefit you’d want, a longer loan term is one reason why plenty of business owners search for debt refinancing.
3. Debt Refinancing Can Offer More Money
This one is pretty straightforward: That second loan comes with a bigger pile of cash you can use to grow your business.
By refinancing your debt with a larger loan amount, you can invest more capital into your business without taking out multiple loans at once or waiting to finish paying off your first round of funding. Of course, a portion of that second loan will go toward paying off your first loan, but so long as what’s left over is more money than you would’ve had otherwise, refinancing makes perfect sense.
More often than not, you would refinance business debt because of some combination of these reasons—maybe even all three.
Now that you understand why you might want to refinance business debt, let’s take a look at the different kinds of business loan debt refinancing, and how each can make a big impact on the success of your business.
There are some drawbacks to business debt refinancing. Let’s evaluate them.
1. Prepayment Penalties
When you’re refinancing debt, you’re essentially paying it all off early—with the proceeds of another loan. But if a lender has attached a prepayment penalty to their loan, this could end up costing you extra money.
A prepayment penalty is when you’re penalized for paying a loan off before its term ends. Prepayment penalties exist because lenders want to recoup what they lent plus interest. If you pay off the loan early, your lender loses out on some interest they expected to receive. They’re not making as much money as they thought, in other words.
Some lenders will charge extra for prepayment in order to make up some of that lost capital. Others offer prepayment “incentives” where they’ll forgive a portion of your interest when you pay early—but only a portion.
Either way, debt refinancing will trigger that prepayment penalty, so watch out. Make sure you’re aware of whether your loan has a prepayment penalty—and how much it is—before you refinance business debt
2. Refinancing Short-Term Debt With Short-Term Debt Can Get Expensive
If you choose to refinance short-term debt with other short-term debt—even if it’s a bit more affordable—then you risk getting “stuck” in a cycle that can be hard to climb out of.
When you refinance one short-term loan with another, you’re paying a good deal of interest on interest. Sometimes that’s a necessary evil if you’re getting much better financing, but it’s not necessarily the most cost-effective option.
Are You Eligible for Debt Refinancing?
Now that you know all about debt refinancing, the last piece of the puzzle is finding out if your debt is eligible for refinancing. To find out, ask yourself these five questions:
1. Are You in the Best Possible Loan You Could Be Right Now?
Being eligible for business debt refinancing means there is room for improvement in your debt repayment situation, and you qualify for an alternative loan. To analyze whether your loan is currently the best it could be, take a long look at the following:
- What type of business debt do you have? This might include business credit cards, equipment financing, invoice factoring, invoice discounting, and overdraft facility.
- What is your current outstanding balance?
- What is your current required monthly loan payment?
- What is the projected date you will pay off this debt?
Consulting with a business lending specialist will help you determine whether you could possibly be making lower debt payments. Lowering your debt obligation is the overall goal.
Depending on the lender and the type of refinancing you qualify for, you may or may not have to pay the debt off in full. For example, if you have equipment loans in short-term debt, you might not qualify for a medium lender to refinance the full $100,000 you owe. However, the lender may choose to carve-out and refinance the short-term debt.
2. What Is Your Credit Score?
As the business owner, your credit score has a big impact on whether your eligible top refinance business debt, as well as which loans you qualify for. This doesn’t simply go for the primary business owner, either; lenders examine the credit histories of all owners holding at least 20% of the business.
The most worrisome situation would be if one of your business owners had a credit score below 600. In that case, you would most likely only be eligible for a short-term loan. While taking on a short-term loan for refinancing isn’t always advisable, it could certainly help if it is the only option available to you.
In some cases, you might want to wait to apply for refinancing until you’ve raised your credit score to at least 620, if not higher. Again, this applies to all primary owners of the business.
3. Have You Declared Bankruptcy? If So, How Long Ago?
Declaring bankruptcy is known to be one of the worst things for your credit score. It often results in lowering a credit score by 200 points, and will remain in your credit history for seven-10 years.
Most long-term lenders with affordable rates won’t qualify anyone who is within four years of their bankruptcy’s discharge date. The SBA requires you to be three years out from the discharge date.
4. Do You Have a Tax Lien You Need to Get Rid of Before Applying?
A tax lien is a legal claim the government has against your property if you neglect—or simply fail—to pay back tax debt. As you may expect, most lenders look negatively upon a tax lien.
If you want to apply for business debt refinancing but currently have a tax lien against your property, you should be proactive in at least reaching good standing with your tax debt. This means being aware of the entire amount you owe. Lenders will note if there is a tax lien against you and whether you are currently on a payment plan to take care of your tax debt. Again, this applies to all primary owners of the business.
5. Is Your Business Currently Healthy?
Finally, the current state of your business plays a very important part in whether you will qualify for refinancing. Just as your credit score should show that you have a good history of making payments on time, your business’ current standing should show lenders that you will continue earning and being able to pay off debt.
Business health factors include monthly cash flow, gross revenue and net profit, and the length of time you’ve been in business. Generally, refinancing lenders want to see that you’ve been in business for at least one year, and ideally more than two years.
The Bottom Line
Taking out a loan to refinance the debt you have can be a serious game-changer for your small business.
Whether you’re making incremental improvements or reaching for the stars, graduating into a significantly better kind of loan can give you more time to access more capital at a more affordable rate.
That’s a lot more—for a lot less.
Here’s the bottom line: Refinancing doesn’t always make sense for every business, but it’s a powerful option for small businesses looking to grow in a big way. So think carefully about your debt situation, your business’s needs, and how your financials have changed since your last loan. Debt refinancing might be just what you need.
Sally Lauckner is the editor-in-chief of the Fundera Ledger and the editorial director at Fundera.
Sally has over a decade of experience in print and online journalism. Previously she was the senior editor at SmartAsset—a Y Combinator-backed fintech startup that provides personal finance advice. There she edited articles and data reports on topics including taxes, mortgages, banking, credit cards, investing, insurance, and retirement planning. She has also held various editorial roles at AOL.com, Huffington Post, and Glamour magazine. Her work has also appeared in Marie Claire, Teen Vogue, and Cosmopolitan magazines.