Debt financing is a type of financial arrangement where you borrow money from a lender or creditor for a certain period over time and at a pre-agreed rate of interest. With debt financing, the loan is paid in regular instalments (usually monthly payments) until the entire amount is paid off.
There are many uses for a debt financing loan. For example, if you want to buy a home but you don’t have enough money for the deposit and closing fees, you may be able to borrow the extra cash you need from a bank. Debt financing can also be used to fund businesses through a loan which is secured against the business’s assets and is paid back using future profits.
However, there are also disadvantages associated with debt financing which include high interest rates and increased risk because either you or your business will be in debt to the lender.
To help businesses and individuals decide if debt financing is the best option available, here is everything you need to know.
What is debt financing?
Debt financing is when an individual or a company borrows money from someone else so that they can make a purchase or an investment. The most common type of debt financing are loans, which can be obtained through banks and credit unions. Leases must be arranged with a leasing company. A person may also arrange a line of credit with their bank or create an installment agreement to pay off the debt over time.
Debt financing can be used for many different purposes, such as purchasing property, funding a business, making investments in stocks, bonds, and other securities, and personal expenditures such as a new car or monthly education fees.
What is the difference between debt financing and equity financing?
Debt financing is when your business borrows money from an institution, like a bank. Equity financing means that someone purchases shares in your company and invests their own funds into it (think Dragons’ Den or Shark Tank.)
You can use either one to fund a business venture, however they each come with different benefits and downsides.
Debt financing has its advantages when used correctly because there are no equity holders with a say in operations. This form of funding is good for people looking to protect their assets while also getting some extra financial help through loans.
On the other hand, equity financing often provides the potential for a bigger investment in your company but at the cost of giving up a percentage of its ownership. This type of financing means you have more responsibility to make sure things go well with your business, but you can also reap bigger rewards if that happens.
For more information, here is a breakdown of the advantages and disadvantages of debt financing and equity financing:
- Debt financing doesn’t require you to give up any control of your business.
- Your company has no obligation to share profits with lenders which increases your chance of success as long as debt payments are made on time.
- Both secured and unsecured options are available.
- Reduced stress on cash flow and increased liquidity in the event of an emergency.
- If your business doesn’t perform well, you can potentially lose everything including ownership and control of the company, as well as any intellectual property rights you have.
- It may be hard to secure financing if you have no credit history or a poor borrowing history.
- Potentially larger investments in your business than through debt financing.
- You will still own some percentage of your business even though there are other investors involved.
- Sometimes investors will be able to give you advice or an advantage in the market. (This is why on Dragons’ Den and Shark Tank there is often one particular investor who the contestants are hoping to bring on board depending on their company’s industry.)
- You give up some equity and, therefore, some control in your company.
- If you want to sell your company, you will either have to agree with the other equity holders or secure the funds to buy them out.
- Potential investors may also want to see your credit history and financial records and may pull out if they are not up to scratch.
What are some different types of loans?
Asset backed loans/Secured Personal loans
Asset backed loans (for businesses) and secured personal loans (for individual people) are loans that are backed by an asset. For a personal loan the asset may be a car or a property, whereas for a business it may be inventory, business premises, or even intellectual property. The advantage of these types of loans is that if you or your business has a valuable asset, you can use it to generate immediate funds.
Mortgage Loans/Home Equity Loan
A home equity line of credit (HELOC) is one type of asset-backed loan with which you can borrow against your home without having to secure the money with other assets like stocks, bonds or mutual funds. To get this type of loan, you will usually need to meet certain requirements from your lender including having at least 20% equity in your house.
This type of loan is for businesses that sell products on credit to their customers and want funding upfront before they have collected all payments from those sales. Invoice financing has a lower interest rate than asset-backed loans because your assets are not being used as collateral. It is important to remember, however, that if you never receive the money you are owed on the invoices, you will still need to repay your invoice financing loan. This will usually mean you taking legal action against your customers to get the money they owe you.
Unsecured personal loans
This kind of debt finance isn’t usually secured by any tangible property besides your own personal belongings (such as jewelry). As a result, unsecured personal loans come at higher rates with APR’s as high as 25%. One benefit is that you can get a personal loan for any amount you need, even if it’s as small as $1000.
A credit line is an agreement between you and the lender that enables you to make purchases or take out loans up to a certain amount without having to get approval from the bank every time you want money. The main advantage of credit lines is that they provide you with more flexibility and often a larger loan amount. However, if you exceed your limit, an over-limit fee may apply plus increased charges for defaulting on payments. Furthermore, if you use credit lines too often, your overall credit score can drop which may impact you or your business in the future.
Peer to peer lending
This is a relatively new type of debt finance that lets you borrow from other people, often with lower rates and without collateral required. This allows for businesses to get help from people who are willing to take on some risk while still offering competitive terms relative to other types of loans.
How can you choose the best debt financing option?
When choosing a debt financing option, you will first need to consider the needs and financial goals of yourself or your business. There are many factors to consider, such as how much you are able to pay back each month and which assets you are willing to risk to secure the loan. You should also take into account the level of interest rates available on different types of loans, which loan term will work best for you (i.e., a variable mortgage or a five year fixed rate mortgage), and whether there are any additional hidden fees or charges. Once all these factors have been considered, you can then compare all of the different options side-by-side before making a decision about which debt financing option is right for you.
How do you repay a debt financing loan?
There are many ways to repay debt financing loans. If you have borrowed the money for a personal expense such as buying a new car, then you will usually pay back the money from your salary or other earnings. If, on the other hand, you borrowed the money to fund your business, the repayments will usually come out of your profits.
You can also use another loan to pay back your original debt financing loan, but you should always be careful about taking on more debt to pay off existing debts. Other repayment options include selling assets such as your car or home to fund the repayments.
If none of these options are possible, however, you may need to consider declaring bankruptcy.
How does debt financing lead to bankruptcy?
Debt financing can lead to bankruptcy if you are unable to keep up with repayments and the lender has a clause in their contract that allows them to pursue legal action when you default on repayments. If you find yourself in this situation, it may be best for you to declare personal bankruptcy rather than allowing the debt finance company or creditor to take control of your assets.
The first step when considering declaring bankruptcy as an option is seeking advice from experts such as lawyers, financial advisers, and credit counsellors, as well as friends who have been through similar situations. They will be able to advise you as to your best course of action so that you are able to hold on to as much as possible following the declaration.
How can you avoid taking on too much debt?
The first way to avoid taking on too much debt, is by making sure that you can afford the monthly payments. Be realistic about what you can afford to pay back each month and avoid taking out loans based on how much you expect to be earning in the future. If your income or your business’s profits don’t match up with your expenditures, then it may be time to consider a new job or ways to make more money. Different types of debt financing have various interest rates and repayment structures, so do your homework and make sure you choose the most suitable and most affordable loan for you or your business.
The second way to avoid putting yourself in too much debt is to pay it off as soon as possible. Many types of debt financing have very high interest rates and by continuing to borrow on top of already existing debt, it is very easy to quickly end up in a deep financial hole. When this happens, all of the money you make will just end up paying back interest without any of the principal ever being paid off until eventually bankruptcy becomes the only option.
Which companies use a debt financing model?
Some well-known companies that use a debt financing model are: Google, Facebook, Amazon.com, and Apple Incorporated to name just a few.
Many small businesses also rely on debt finance in order to grow their businesses or keep them afloat during difficult times like the recent Covid-19 pandemic. Debt financing allows business to expand operations without having to come up with all the money upfront or risk losing everything overnight if things don’t turn out as expected. There is no shame in borrowing money from time-to-time when you know your company will be able to pay it back eventually.
To sum up…
Depending on your business needs, debt financing can be a useful way to get the money you need to invest in growth, pay inventory or expenses, or just maintain your operations. Debt financing will allow you to keep control of your company and retain 100% equity while still getting the cash you require to run your business. There are various different types of debt financing options available depending on what type of assets you have for collateral and how much money you want to borrow. Interest rates can vary based on various factors so make sure you do your homework before signing on the dotted line.