Managing Debt for Your Small Business: Debt Consolidation vs. Refinancing

By Brandon Amoroso

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Is your small business struggling to meet its loan payments? You’re not the only one. Thousands of business owners find themselves in less-than-ideal financial straits every year, and engaging in debt relief strategies can often mean the difference between bankruptcy and staying afloat. Debt relief isn’t reserved just for struggling businesses. Small businesses looking to clean up their expenses and find cost savings can shop around to lower their overall loan payments, extend their term length, or get a new loan with more favorable terms. This can provide a new source of funds for small businesses as they free up resources, facilitating the opportunity to increase business growth through better financing terms.

What is Debt Consolidation?

Debt consolidation means taking out a new loan to pay off a number of liabilities and consumer debts, generally unsecured ones. In effect, multiple debts are combined into a single, larger loan, usually with more favorable payoff terms: a lower interest rate, lower monthly payment or both. It’s usually easier to keep track of a single payment then to keep up with multiple different debt payments. Hence, the growing popularity of debt consolidation in the financial world. With multiple short-term loans, consolidating to a longer-term loan actually buys you more time to pay off your loans.

Secured vs. Unsecured

Secured debt consolidation loans are typically what you’ll find at banks and credit unions. They use collateral, such as business assets like equipment or property, and will typically have better interest rates than their unsecured counterparts. Collateral is pledged as security for the repayment of the loan. In the event of a default, the collateral offered up in the loan will be seized by the bank or credit union to cover the remaining balance of the loan. Unsecured debt consolidation loans don’t require any collateral and are usually easier to get. Unsecured loans can be obtained online and make getting a loan convenient, but interest rates will be higher than secured loans because the lender doesn’t have the same guarantee that the loan will be paid back.

Personal vs. Business

Aside from secured vs. unsecured, when consolidating business debt you can choose to do so through a personal loan or through another business loan. With the personal loan, you’ll be using your own credit, not the business’s. This can be helpful if you have a stronger credit history than your business, but it also makes you liable financially for payments and for any collateral requirements in the case of a default. With a secured personal loan, your own personal assets will also be on the line. Whether or not you choose a personal loan or a business loan depends on the financial health of the company and your willingness to take on personal risk, making this choice extremely important.

How to Consolidate Debt

Now that you know what debt consolidation is, how do you actually go about combining multiple loans into one large debt payment plan? Let’s say you have three different loans: a balance of $3,000 at an interest rate of 20%, $4,000 at an interest rate of 23%, and $6,000 at an interest rate of 25%. One of the ways to consolidate is to take out a new loan for $13,000 and use it to pay off all the outstanding debt. This consolidated loan could have a similar interest rate or a variable rate depending on the terms of the deal. Now, you only have one loan to monitor and make payments against. Remember, this scenario would truly make economic sense as long as your interest payment on the new loan ends up being less than the combined payments you were making on your previous three, or you benefit from having a longer period of time to pay it back.

What is Refinancing?

Refinancing occurs when a business or person revises the interest rate, payment schedule and terms of a previous credit agreement. The goal of refinancing is to optimize an existing debt, rather than consolidating multiple debts, by replacing the terms of an existing debt with a loan that has better terms. A longer term loan would shave down your monthly payment or allow you to keep a monthly payment similar to your current one while taking out a larger principal amount and thereby borrowing more overall. A lower interest rate would save you money by accruing less interest over time.

How to Refinance Debt

So how do you refinance debt? Let’s say you have a 10-year business loan at a fixed interest rate of 10 percent. However, the market rates have gone down and at this point you could take out a new loan at 7.5%. So, if you can find a lender who’s willing to work on a deal like this you can refinance your business loan by applying for a new loan and use it to pay off the old one.

The US Small Business Administration provides a guide to situations where refinancing loans may be applicable.

Debt Considerations

First and foremost, you have to take a look at your business and how it has performed since you took out the last loan. If your credit or revenue hasn’t improved since then, it’s unlikely that you and your business will be able to find a better financing option now, especially since you have more debt that you did last time you were looking. Pay attention to two key areas in particular.

APR vs. Interest

Be sure to take a closer look at your new financing options and look at the APR of the various loans. APR will include all the additional fees you will have to pay each year and will give you a complete picture of the total cost of the loan each year. Just because the interest rate is lower on a refinancing or consolidation loan doesn’t mean that the overall cost of the loan will be lower as well. Term length also substantially impacts the expensiveness of the repayment schedule.

Prepayment Penalties

Prepayment penalties are another example of a situation where rates may lie. Even though a new loan you are considering may have a lower interest rate, you might not save any money by paying it off early and refinancing. In fact you may lose money from paying it off early. Prepayment penalties are fees your original lender may have set up in your original loan contract in the case that you close the loan before your full term length is up. Lenders often add these in as a protection for the money they loan out. If you can get a great new loan that allows you to still save money in spite of the prepayment penalties on your current loan, then go ahead. If the penalties outweigh the cost savings you will get from the consolidation or refinancing of your debt, then it might be a good idea to hold off.

Debt Consolidation vs. Refinancing

The outcomes of debt consolidation and debt refinancing are often very similar, and in some instances businesses may refinance and consolidate debt at the same time. So how do you decide which is the best option for you and your company’s needs?

It really depends on the situation. If you’re a business overwhelmed by multiple loans and lots of different payment dates each month, debt consolidation can be a way to minimize administrative costs and simplify your finances, and in the process possibly save money. If you’ve identified that you’ve got just one loan that has an unfavorable APR based on the current interest rates, refinancing may be your best option.

Whether you decide to consolidate, refinance, or both, be sure to talk to a funding expert you can trust about what works best for your business. The last thing you want to do is to maneuver your business’s debt into a situation that is less favorable than the current situation or miss out on an excellent deal that could be a catalyst for growth for your small business.