Debt finance provides individuals and businesses with a way to access capital by borrowing money from a lender that must be repaid over time, typically with interest. Whether for a personal expense for a new car or home, or need a capital injection for your business operation and growth goals, debt financing offers a variety of loan options to suit your circumstances.
There are mortgages, personal loans, business credit, invoice financing available and more but taking on debt does come with risks. Interest payments are often high, and if you fail to repay the agreement amounts at the scheduled instalment dates, you could lose any assets secured against the loan.
Read on to understand the pros and cons of some of the popular debt financing options available so you can decide if and how to make use of borrowed funds.
What is debt financing?
Debt financing is a means of borrowing money from a person or entity in order to cover your or your business investment and other purchase costs.
Loans from banks and credit unions are one type of debt financing, and leasing products from companies is another example. A line of credit like an overdraft or credit card from a bank is also a type of debt financing.
Debt financing is useful for many types of expenses. You can use it as an option to buy properties, fund your business and acquire bonds, stocks or any other securities. Personal expenses may also be covered by debt financing, for example, you can get a brand new car or pay off your school tuition fees.
What is the difference between debt financing and equity financing?
Debt financing and equity financing are different. If your business takes out a loan from institutions, that is debt financing, like bank loans. On the other hand, when a party invests in shares at your company and puts funds in, that is equity financing. An example would be Shark Tank or Dragon’s Den type of agreements or investments.
Whether you go with debt financing or equity financing to fund your business operations, each will have its own advantages and disadvantages.
One good advantage with debt financing is exclusive control. You are able to better protect your assets. You source external financial help in the form of loans, but, because there are no other equity holders to deal with, you have sole authority in the administration and operation of your business.
However, if you’re looking for investments to pour into your company and don’t mind sharing ownership with others, you should look into equity financing. While operational responsibilities are greater, the potential for benefits and rewards are also greater when you have co-investors in your business.
Debt financing and equity financing both offer their own accompanying advantages and disadvantages. We break it down for you below, so keep reading.
Debt Financing
Advantages:
- You don’t have to share control over any aspect of your business
- You won’t have to divide profits with others, thus, giving you a higher success rate, provided that you settle your loan payments in due time.
- You have the option to choose between secured or unsecured loans.
- Your business has a freer cash flow and higher liquidity rate in case of emergencies.
Disadvantages:
- Your business is more vulnerable to risks and losses if it performs poorly. You can lose everything including intellectual property rights and control over your business.
- You may experience difficulty in securing this type of financing especially if you have zero credit history or a bad credit history.
Equity Financing
Advantages:
- You have more opportunities for investments going into your business as compared to debt financing.
- You maintain control over a part of your business despite having other investors on board.
- You gain better insights and strategies when you bring other investors in. They carry their own expertise and that gives you an edge over other business competitors. This is why a lot of contestants on shows like Shark Tank and Dragon’s Den target a particular investor when presenting their company to the group.
Disadvantages:
- You lose full control over your business since you have to give up a portion of the equity.
- Selling your company is more difficult since you have to either get the consensus of other stakeholders or buy their shares before you could sell the company.
- It’s difficult to attract investors if you have a poor or unproven credit history and/or financial standing.
What are some different types of loans?
Asset backed loans/Secured Personal loans
A loan which is backed by one’s asset is called an asset backed loan for a business. For an individual, this type of loan is called a secured personal loan. Individuals can use their cars or real properties to apply for a secured personal loan. With businesses, inventories, intellectual property rights and business premises can be used to apply for an asset backed loan.
Mortgage Loans/Home Equity Loan
Home Equity Line of Credit or HELOC is an asset backed loan. Here, you can take out a loan against your home. When you do this, you don’t have to secure the loan with additional assets such as stocks and bonds or even mutual funds. Often, lenders grant this type of loan only when there is a minimum of 20% equity in a borrower’s home. Other requirements apply before you can be eligible for such a loan.
Invoice financing
Some businesses sell products on credit. They may take out an invoice financing loan when they want the fund even before the collection has been made on those sales on credit. Invoice financing loans charge lower interest rates but if customers fail to make payments on those credit sales, you’d have to pay back any invoice financing loan with your own money. You may even have to take legal action against customers to get paid on the amounts payable to you.
Unsecured personal loans
An unsecured personal loan doesn’t have to be backed by any asset except personal belongings such as jewellery. You can apply for unsecured personal loans for even as low as $1000. However, this type of loan charges higher interest rates of up to 25% APR.
Credit lines
Credit lines are pre-approved loans. The lender gives you a maximum amount you can use up when you need money. This type of loan is more flexible and you can often borrow a large amount. Be careful not to exceed your limit. Otherwise, you may have to pay over-limit fees and additional charges if you default on payments. You also have to be careful not to resort to credit lines a lot. This can affect your credit score negatively and, thus, put your business at a disadvantage.
Peer to peer lending
This is a new type of debt financing. With this loan, you can borrow money from other people without any need for a collateral. A lot of peer to peer lenders charge lower rates which is good for businesses that need financial help at reduced risks. Peer to peer lending offer competitive terms compared with other kinds of loans.
How can you choose the best debt financing option?
Before choosing to go into debt financing, you have to evaluate your needs and financial goals and/or that of your business. You have to consider your capability to make loan payment amounts as they become due. You also need to determine the assets you can put at risk and use for secured loans.
A comparison must be made on interest rates and terms per loan type to see which option is suitable for you or your business situation (for instance, variable mortgage vs fixed rate mortgage). Check and confirm if there are other charges or fees and add it to the figures. Complete a thorough search and table all costs side-by-side so you can make an informed decision on which type of debt financing is best for you or your business at this time.
How do you repay a debt financing loan?
You can pay for your debt financing loan in several ways. If you purchased a new car or loaned an amount for personal expense, your salary and/or other income can cover the loan payments. If you took out a loan to finance your business, you would be making loan payments from your business profits.
You also have the option of taking out a different loan to cover payments for your existing debt financing loan. Great care must be taken when choosing this option since you are adding more debt on top of your current amount owed. You may sell assets (a house, car etc.) instead of taking out another loan.
How does debt financing lead to bankruptcy?
Debt financing can spiral into bankruptcy if you become unable to make the repayments due. Lenders require provisions in loan agreements that allow them to take legal action should a borrower default on the loan.
This means that if a business or individual takes on too much debt relative to their ability to repay, they can quickly become overwhelmed in the amounts due. From penalty fees and seizure of assets listed as collateral.
As the debt increases and penalties rack up, the amount owed compounds over time and this can eventually leave bankruptcy as the only option available to remove the burden of the unpayable debt.
How can you avoid taking on too much debt?
Before taking out any loans, alway look over your finances first to confirm that you can cover the upcoming monthly payments for a new loan and any existing ones. It’s important to be realistic about your financial capability to make repayments.
Avoid banking on your future or expected earnings as results aren’t always as expected. You’d be in financial trouble if your profits don’t measure up and you aren’t able to cover your loan payments.
If your job or business is not able to handle current expenses, then instead of taking out loans, it might be better to explore a new job or business so you can make more profit to cover your expenses or that of the business.
You can also avoid being in too much debt by paying off your loans as soon as you can. A lot of debt financing contracts charge exorbitant rates and fees. You may even end up just paying back interest fees and none or very little of the principal loan amount.
Which companies use a debt financing model?
A lot of companies use debt financing for their business. These include Facebook, Google, Apple and Amazon. There are more well-known businesses that go into debt financing to fund their operations.
Small businesses also use debt financing as an option to expand their businesses or to help them through challenging times such as the Covid-19 pandemic. Through debt financing, small businesses are able to grow their business even if they don’t have all the money required. It can be beneficial to borrow money in times of emergencies or during business expansion. However, you must be fully confident and sure of your finances so that you or your business can make the loan repayments.
To sum up…
Debt financing helps individuals and businesses to meet their goals and investments that they may not be able to meet without access to the upfront capital required. Borrowing money does come with risks and strict repayment obligations so it’s important to understand the terms of any loan and be able to make the repayments needed before entering any agreement for debt finance.
Financial advisors can help you to review your circumstances and make informed decisions on the best way to proceed with your finances. With the right planning, debt financing can be a valuable tool in reaching your goals.
