Just reading the word “debt” may cause some perspiration to start forming on your forehead. Deciding to take on debt for your business can be intimidating if you’re not familiar with how it all works.
Let’s get one thing straight: Debt isn’t inherently bad. Taking on debt — whether it’s through a loan or a line of credit or some other options — can allow you to grow your business (if it’s used responsibly).
You should do your own research and talk with your legal and/or financial advisors about what financial tools will work best for your business. To get you started, let’s review some key concepts.
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What’s the difference between credit and debt?
Credit often refers to a designated financing amount that you are permitted to borrow from some financial institution. But you haven’t borrowed it yet. So if you have a credit card with a $5,000 limit, you have $5,000 in credit.
Whatever you borrow — and owe to the financial institution — is debt. So if you spend $100 on your credit card, you have $100 of debt and $4,900 of credit.
What is revolving credit?
Revolving credit includes open-ended accounts, often with predetermined credit limits and payments that are calculated as a percentage of the unpaid balance. If you have a credit card, you have revolving credit.
Let’s continue using credit cards as an example. With a credit card, your credit limit does not change from month to month. And you can keep borrowing against it, as often as you want, as long as you do not exceed your maximum credit limit. You may pay off your monthly balance, but if you don’t, the bank or creditor charges interest on the unpaid balance each month.
Lines of credit are also a type of revolving credit and function in a similar way. One big difference with a line of credit is that you have access to cash. Learn more about lines of credit.
What are the benefits of revolving credit?
Revolving credit offers flexibility both in terms of usage and payment. Because you can apply for it without a specific purpose in mind, you can have it on hand in case you need it. That means that you could use it in the case of an emergency or an unexpected expense.
Instead of using your personal credit card to fund your business needs, utilizing a separate business line of credit or business credit card product allows you to separate your personal and business finances, as shared by the Small Business Association. With successful repayment on your business credit or loan product, you can build up your business credit profile, which is separate from your personal credit report.
What are the challenges of revolving credit?
There are a handful of challenges that are important to be aware of before utilizing revolving credit.
If you spend more than you can afford, or max out your line of credit, you can hurt your business finances and credit profile. And if your credit account has a high interest rate, you could spend money on paying back your debt instead of saving or growing your business.
If you take revolving credit, be aware of the terms and conditions set by the institution with which you’re working. Pay attention to the fees and interest rate you could pay, how your balance is calculated, how you earn rewards, and more.
What is installment credit?
You may be familiar with installment credit if you’ve ever taken out a term loan — whether that was a mortgage, an auto loan, a student loan, a private personal loan, or a loan for some other purpose.
Installment loan products have a predetermined length and an end date (sometimes called the term of the loan) by which you have to pay back the amount borrowed. Installment loans are paid back in fixed, scheduled payments, or installments. The agreed-upon schedule for paying back the loan is called an amortization schedule.
What are the benefits and challenges of installment debt?
Investopedia states that installment debt has the upside of being less risky for your credit score than revolving credit.
This has to do, in part, with the fact that you can’t continue to borrow against installment debt. The funds are given to you all at once, and once you pay it all back, you need to apply for a new loan (unlike with a credit card, which lets you continue to borrow). This also means that you can’t max out your balance.
And since installment credit has a fixed repayment period, it may give you more visibility into your cash flow needs, making it easier to budget and plan for your business.
Some of the challenges of installment credit include:
- Traditional loans can have long application processes.
- You need to make fixed payments on a regular basis.
- You often need to apply for installment credit with a specific purpose in mind; it’s not a tool that you necessarily have waiting on hand for an emergency.
- If you need additional funds once you’ve paid back your loan, you have to apply again.
So what do you do next?
When used correctly and responsibly, financial tools — whether it’s a loan or a line of credit or a credit card — can be useful for both short- and long-term business growth. But before you dive in, make sure you do your research, compare lenders, and consult with your accountant or financial advisor.
This communication is for informational purposes only and is not intended as financial or legal advice. Square Capital, LLC is a wholly owned subsidiary of Square, Inc., d/b/a Square Capital of California, LLC in FL, GA, MT, and NY. All loans are issued by Celtic Bank, a Utah-Chartered Industrial Bank. Member FDIC, located in Salt Lake City, UT. Loans are not issued to borrowers in ND. The individual authorized to act on behalf of the business must be a U.S. citizen or permanent resident and at least 18 years old. All loans are subject to approval. FM0417