Pros and cons of working capital loans
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Working capital loans help companies borrow money to cover cash shortfalls and pay for everyday expenses like payroll or inventory purchases. Even profitable businesses can face liquidity issues, which working capital loans help alleviate.
Though working capital loans can help your company make ends meet, there are drawbacks to consider before relying too heavily on them.
What are working capital loans?
A working capital loan is a type of short-term business loan. They usually have quick applications and funding, helping businesses borrow money to meet immediate needs such as paying the rent or covering payroll. They also tend to have short repayment terms, usually no more than a year or two.
Companies that don’t have enough cash on hand to pay for daily operating costs can use working capital loans to help make up the difference.
Types of working capital loans
There are many different types of loans that you can use for working capital, including term loans and business lines of credit. Each works a bit differently and is designed for different uses. Knowing which is right for your situation can help you find the best loan.
|Working capital loan type||Description|
|Term loan||Traditional loans offering a lump sum upfront and regular payments over the next weeks, months, or years.|
|SBA loans||Large loans that are insured by the Small Business Administration. Approval can take longer but loan limits are much higher.|
|Lines of credit||Flexible credit lines let you draw money multiple times on an as-needed basis. You only pay interest on the current balance of the line of credit.|
|Business credit card||Flexible credit lines designed for everyday purchases. No interest is charged if you pay the balance off each month.|
|Invoice financing/factoring||Financing secured by the value of your unpaid invoices. You can get paid a percentage of what you’re owed immediately, with automatic repayment when your customers pay the invoice.|
|Merchant cash advance||Small, quick loans intended for things like buying inventory or small immediate expenses. Payment is made automatically by sending a percentage of future sales to the lender.|
Pros of working capital loans
Working capital loans have many advantages that make them a popular choice for businesses needing financial flexibility.
Because working capital loans are intended for paying day-to-day operating expenses, lenders prioritize speed when it comes to approval and funding timelines. This is especially true of online lenders who can often approve your application within minutes and put money in your company’s checking account the next day.
May not require collateral
Many working capital loans don’t require collateral, reducing the risk you face as a borrower. It also makes the application process easier because you don’t have to wait for the lender to appraise your collateral and ensure it’s worth enough to secure the loan.
Relaxed eligibility requirements
Most lenders, especially online lenders, will have easier eligibility requirements for working capital loans. This helps make them more accessible for startups and business owners with bad credit — borrowers who typically struggle to access funding from traditional lenders like banks and credit unions.
Cons of working capital business loans
The best short-term business loans can help when a business needs quick cash, but they have some important drawbacks to keep in mind.
Smaller loan amounts
The amount you can borrow using a quick working capital loan is typically much smaller than with longer-term loans or loans with more involved underwriting processes.
For example, many online lenders specializing in fast working capital loans typically have limits of $100,000 or $250,000 for term loans and business lines of credit. This is much smaller than the limits of $500,000 and higher banks offer.
Short repayment terms
Working capital loans are intended for short-term use, so lenders expect to be paid back relatively quickly. Expect repayment terms of 18 months or less on many working capital loans, especially from lenders working with business owners with fair or bad credit.
Sometimes, you may find working capital loans that will give you two years or more to pay the money back. This includes lenders like SMB Compass, which offers bridge loans with terms of up to 36 months.
With most loans, the expectation is that you’ll get a bill once a month and have to make payments once every month. With working capital loans, that timeline can accelerate. Many lenders ask for bimonthly, weekly or even daily payments depending on your loan details.
If you’re already facing cash flow issues, needing to make frequent debt payments can compound those problems. If you’re not careful, you could end up defaulting on your loan or falling into a cycle of debt.
Because working capital loans have quick approvals and less stringent requirements than other loans, many lenders charge higher rates and fees. Certain high-risk alternative loans, like invoice factoring, merchant cash advances and business lines of credit open to business owners with poor credit, may use factor rates rather than interest rates. Factor rates are expressed as decimals, typically ranging from 1.1 to 1.6, and can be a costly form of borrowing if you aren’t careful.
Before accepting a loan that uses factor rates, make sure you convert it to interest rates to compare with other loans and better understand how expensive these loans are. Our guide on factor rates will show you how.
Working capital loans can help companies facing liquidity issues come up with the funds they need to pay their daily operating costs. Their quick approvals and easy eligibility requirements make them an easy way to borrow money. But relying on them too much can balloon costs and ultimately exacerbate your business’s financial woes.
If you decide that a working capital loan is right for you, select the right type of loan and shop around to find the best deal.
Frequently asked questions
Yes, the SBA offers working capital loans. You can use the organization’s CAPLine lines of credit or SBA Express loans to cover working capital needs.
Each lender sets its own requirements to qualify for a loan. Typically, online lenders have lower requirements than banks or credit unions and you can qualify with a score of 600 or even lower. A low credit score, however, will mean high borrowing costs.
Working capital loans help cover short-term borrowing needs. They offer many benefits, including quick approvals and funding, simple loan applications and lower eligibility requirements, than other types of business loans.