Pros and cons of working capital loans

Working capital loans allow businesses to borrow money to cover cash flow deficits and pay for day-to-day expenses, such as salaries or stock purchases. Even the most profitable businesses can have cash flow problems, which working capital loans help alleviate.

Although working capital loans can help your business make ends meet, there are drawbacks to consider before overusing them.

What is a working capital loan?

A working capital loan is a type of short-term business loan. Applications and financing are usually quick and allow businesses to borrow money to meet immediate needs, such as paying rent or salaries. The repayment period is usually short, not exceeding one or two years.

Businesses that lack sufficient cash to pay day-to-day operating costs can turn to working capital loans to make up the difference.

Types of working capital loans

There are several types of working capital loans, including term loans and business lines of credit. Each works slightly differently and is designed for different purposes. Knowing what is right for your situation can help you find the best loan.

• Term loans: traditional loans that provide an initial lump sum payment and regular payments over the following weeks, months or years.
• SBA loans: large loans insured by the Small Business Administration. Approval may take longer, but loan limits are much higher.
• Lines of credit: Flexible lines of credit allow you to draw money in installments as needed. You pay only 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 off the balance each month.
• Invoice financing/factoring: financing secured by the value of unpaid invoices. You can get a percentage of what you owe immediately, with automatic repayment when customers pay the invoice.
• Merchant cash advance: these are small quick loans for stock purchases or small immediate expenses. Payment is made automatically by sending the lender a percentage of future sales.

Advantages of working capital loans.

Working capital loans have many advantages that make them a popular choice for businesses in need of financial flexibility.

Rapid financing

Because working capital loans are intended to pay day-to-day operating expenses, lenders prefer fast approval and funding times. This is especially true for online lenders, who can often approve your application in minutes and have the money in your company's bank account the next day.

Possibility of being unsecured

Many working capital loans do not require collateral, which reduces the risk to the borrower. In addition, the application process is simpler because there is no need to wait for the lender to evaluate the collateral and make sure it is of sufficient value to secure the loan.

Less stringent eligibility requirements

Most lenders, especially online lenders, are relaxing eligibility requirements for working capital loans. This makes them more accessible to start-ups and business owners with bad credit, who usually have difficulty obtaining financing from traditional lenders such as banks and credit unions.

Disadvantages of working capital loans

The best short-term business loans can be useful when a company needs quick liquidity, but there are some important disadvantages that must be taken into account.

Lower loan amount

The amount that can be borrowed with a quick working capital loan is usually much lower than with long-term loans or loans with a more complex underwriting process.

For example, many online lenders that specialize in rapid working capital loans set limits of $100,000 or $250,000 for term loans and business lines of credit. These limits are much lower than the $500,000-plus limits offered by banks.

Short repayment terms

Working capital loans are intended for short-term use, so lenders expect to be repaid relatively quickly. Many working capital loans have repayment terms of 18 months or less, particularly those provided by lenders working with entrepreneurs with poor or weak creditworthiness.

Sometimes it is possible to find working capital loans with a repayment period of two years or more. This is the case with lenders such as SMB Compass, which offers bridging loans of up to 36 months.

Frequent payments

With most loans, you can expect to receive an invoice once a month and make payments once a month. With working capital loans, this schedule can be accelerated. Many lenders require biweekly, weekly or even daily payments, depending on the terms of the loan.

If you already have cash flow problems, the need to make frequent payments can make matters worse. If you are not careful, you run the risk of defaulting on your loan or getting into massive debt.

Higher costs

Because working capital loans are approved quickly and have less stringent requirements than other loans, many lenders charge higher rates and fees. Some alternative high-risk loans, such as invoice factoring, cash advances for merchants, and lines of credit open to entrepreneurs with bad credit, may use factoring rates rather than interest rates. Factoring rates are expressed in decimal places, usually 1.1 to 1.6, and can be an expensive form of lending if care is not taken.

Before taking out a loan using factoring rates, be sure to convert them to interest rates so you can compare them with other loans and better understand the cost. Our guide to factoring rates will show you how to do this.

Working capital loans can help struggling businesses find the funds they need to pay for day-to-day operating costs. Quick approval and simple eligibility requirements make them an easy way to get a loan. If you decide that a working capital loan is right for you, choose the right type of loan and look for the best deal.

Frequently asked questions.

Does the SBA offer working capital loans?

Yes, the SBA offers working capital loans. You can use the organization's CAPLine or SBA Express loans to cover your working capital needs.

What is the credit score required to obtain working capital?

Each lending institution sets its own requirements for obtaining a loan. In general, online lenders have lower requirements than banks or credit unions, and you may qualify with a score of 600 or even lower. However, a low credit score means high borrowing costs.

What are the benefits of a working capital loan?

Working capital loans are used to cover short-term borrowing needs. They offer many advantages, including quick approvals and funding, simple loan applications, and less stringent eligibility requirements than other types of business loans.

Written by

Irene Scott

Insurance

I’ve worked for more than 5 years as a Credit Analyst and more than 4 years as an Internal Auditor for one of the leading global financial institutions. I have been exposed to the credit review process, various banking products, financial security topics, corporate governance, operational risk, and the internal control framework of a complex, multinational organization.

Read more from Irene Scott