The Definitive Guide to Financing Payroll Costs

There are few greater nightmares for a small business than missing payroll. It’s a scenario that cuts to the heart of the credibility of a business and its owner.  Paying employees late can also create panic among the staff of a small business, and can even have legal consequences. While business may be good – and accounts receivable strong — working capital may be lacking when payroll is due. What can a small business owner do?

One potential answer can be a payroll loan, or a cash advance for payroll expenses.  With a payroll loan, small business can smooth its cash flow to meet its payroll obligations.  For a business owner, payroll financing can come from a short-term loan, a cash advance, a line of credit or invoice factoring. All of these options provide working capital quickly enough to cover the cost of a payroll.

Payroll loans should only be used as a last resort when a small business is in danger of not meeting its payroll.  Using a loan for payroll expenses can be expensive. If you need funding in an emergency situation such as a shortfall at payroll time, your business will not have as many options. So what are payroll loan rates?  In a word, high. Interest rates can range as high as 30 percent or greater, so it’s prudent to look at other funding options first before pursuing a payroll loan. Still, there are times when financing payroll costs through a payroll loan may benefit a small business.

What Are Payroll Loans?

Payroll loans are a type funding that a small business can use to pay its associates.  Several types of financing options can be used to cover payroll expenses, such as lines of credit, invoice financing, invoice factoring and merchant cash advances. The common thread between all of these options is that they can provide fast approval and funding so a small business can cover its immediate monthly payroll needs.

When is a Payroll Loan Appropriate?

Here are the most common scenarios in which a payroll loan can be a suitable solution for a small business:

1. Short-Term Cash Shortage. Cash flow for a small business can be unpredictable.  The need to urgently repair or replace equipment, for instance, can throw an unwelcome wrinkle into the finances of a small business.  A short-term payroll loan can be the answer to such a problem, especially if revenue from outstanding invoices is expected soon. This can sometimes happen in a business such as when payroll taxes are prepaid or when a new employee benefit drives up the total cost of meeting payroll obligations. In these cases, a business owner can use payroll financing to smooth out the cash shortfall and still make sure their employees, and the government, get all the money they require with no delay.
2. Seasonal or Temporary Labor.  Seasonal businesses – such as vacation resorts – typically hire additional employees to accommodate the demands of the business.  Payroll, however, can be due before any revenue from the uptick in business arrives.  A payroll loan can bridge that gap.
3. No Approval from Traditional Lenders.  The process of being approved for a small business loan from a traditional lender can be lengthy and time-consuming. For small businesses who can’t afford to wait it out – or for those cannot get approved for traditional business loans – and are in danger of missing payroll, a payroll loan might be the only option.

Before applying for a payroll loan, small business owners should also ask themselves if they can quickly repay the loan.  If not, they may need a longer-term financial solution. Small business owners should also consider how much they need to borrow and their credit score.  Both of these factors will impact the amount needed to be repaid and their financial stability.

How Do Payroll Loans Work?

The lack of leverage of small businesses seeking payroll loans is why payroll interest rates are why interest rates for payroll loans tend to be higher than other loans, with rates that can range from 15 to 30 percent. The actual rates and terms of payroll loans depend on the specific type of loan and the financing company.  

But, in general, payroll loans can be funded in one day. Because of the urgent need for a quick approval and funding, payroll loans are typically issued by online alternative lenders.  Loan amounts typically start at $250,000 and rates start at 10 percent. Terms of payroll loans can range from three to 18 months, with a daily or weekly repayment schedule, instead of a long-term repayment schedule that can last for months or years.

Payroll Loan Options for Small Businesses

Small businesses owners caught in a cash crunch may wonder, “Can I get a loan to pay my employees?” While the answer is yes, the solution to some small businesses may already be in their grasp before they even apply for a loan.  For instance, if a small business has already has a line of credit or unpaid invoices, they may not need a payroll loan.  So how do you finance payroll? When it comes to financing payroll, small business owners have several options. 

1. Short-Term Loans. Since online lenders can approve and provide financing quickly, short-term loans can be a desirable option for small business owners.  To qualify for a short-term payroll loan, businesses typically need to have been in business for at least nine months with an annual revenue of over $100,000.  The business needs to have a credit score of over 550.
2. Business Line of Credit. Small business owners who are in danger of missing payroll for more than a few months may want to consider opening a business line of credit.  While short-term loans have limited repayment terms, business lines of credit involve revolving credit. 

Small business owners can access these funds at their convenience, and only pay interest on the funds used. Once the funds repaid, the line of credit returns to its original amount.  This flexibility – and the fact that the funds can be used in other areas besides payroll – make a line of credit an attractive financing option for small business owners.

Business lines of credit can offer a credit limit ranging from $10,000 to $1 million and repayment terms anywhere from six months to five years with interest rates starting art seven percent. Qualifying businesses need to have been in business for at least a year, with annual revenue of over $100,000 and a credit score of more than 550.

3. Invoice Financing.  In this form of payroll financing, small business owners receive a cash advance from a lender, which is typically 85 percent of the value of the outstanding invoices of the business.  The business then receives the remaining 15 percent – minus fees – when the invoices are actually paid.

Invoice financing is often easier to get than other types of payroll financing.  New businesses with less of a credit history or a lower credit score are generally more likely to qualify for invoice financing since the value of the outstanding invoices outweighs the financial strength and credit score of the business.

Small business owners can qualify for loan amounts from $500 to $5 million through invoice factoring and can receive payroll funding in as soon as one day. Repayment terms depend on when the invoice is paid.  Factor rates of three percent weekly on the amount advanced make invoice financing a potentially expensive option.

4. Invoice Factoring. This method of financing is not a loan, but it’s preferred by businesses with substantial outstanding invoices to fund large amounts.  Small business owners can borrow against their unpaid invoices through invoice factoring.  Invoice factoring differs from invoice financing in that it allows business owners to sell open accounts receivable to a factoring company.  Like invoice financing, invoice factoring allows business owners to receive an advance of up to 85 percent of the total amount of an unpaid invoice.

Once the invoice is paid, the factoring company will forward the balance of the invoice to the business owner after subtracting a factoring fee of anywhere from one to three percent.  This interest normally begins to accrue once the invoice is paid in full rather than when it’s purchased by the factoring company. Factoring companies have minimum and maximum amounts they will provide, and these amounts are typically determined by the size of the company.

Since funding decisions are based on the credit of their customers, small businesses with bad credit or no credit can qualify for invoice factoring. There are no upfront fees involved in invoice factoring. Approval can take three to five business days and, in some cases, a business can receive initial funding within 24 hours of setting up an account. These figures can range from zero to well into the millions.

5. Merchant Cash Advance. Using a merchant cash advance for payroll expenses can also be a fast option for businesses that have a shortfall of cash to make payroll. A merchant cash advance is not actually a loan; it is a lump sum of funds for merchants that is paid to them in advance of their future sales. Whenever the merchant makes a subsequent sale, a small amount of that sale is repaid to the merchant cash advance company (MCA). The MCA and the merchant normally work together to estimate future sales and agree on the percentage of sales that will be repaid.

   Even with such an agreement, the advance must be paid in full, but it does not carry a defined covered period of time, which makes it a flexible form of financing that does not require fixed payments. Instead, payments can fluctuate along with the number of sales the business makes. Interest rates and repayment terms can vary depending on the MCA used. MCAs charge a fee called a factor rate that is used to express the total amount that will be paid back. This is different than an interest rate, given that there is no fixed repayment term or fixed amounts. As such, this option is works for small businesses that need flexible funding terms, yet need enough funding to make their business more functional and cover expenses like payroll costs.

Can SBA Loans Be Used for Payroll?

The Small Business Administration (SBA) offers several loans that can be used for business expenses including payroll. These loans include the SBA’s popular 7(a) loans and microloans. 

In addition, the SBA’s recent Paycheck Protection Program (PPP) provided loans to help business owners pay their employees during the COVID-19 pandemic. While applications have closed and PPP loan forgiveness are ongoing, any funds received from the program can still be used for payroll expenses.   

Small business owners – especially sole proprietors – frequently ask, “Can I use a business loan to pay my salary?”  The answer is yes, if there is sufficient funding.  According to the SBA, loans can be used for operating expenses such as equipment, materials and payroll.  The salary of the business owner falls under the category of payroll.  But small business owners are advised to be conservative in what they pay themselves out of the loan since, until the loan is paid off, how the funds are used will be closely watched. 

Small business owners and sole proprietors can use Paycheck Protection loans to compensate themselves for wages lost due to revenue loss from the COVID-19 pandemic.  The same is true of Economic Injury Disaster Loans (EIDL) provided by the SBA, although small business owners can’t pay themselves out of these loans unless it’s for work they do in the business.  The terms of the EIDL clearly note that the loan can’t be used to pay “Disbursements to owners, partners, officers, directors or stockholders, except when directly related to performance of services for the benefit of the applicant.”

How to Get a Payroll Loan

The application process for a payroll loan can vary depending on the lender and type of lender. Traditional banks may want business owners to apply in person at a branch.  Alternative lenders, meanwhile, typically offer a brief online application.

Both banks and alternative lenders will need basic information on the business, such as name, address, business structure, time in business and annual revenues, number of full-time employees. Business owners – and any business partners — should also be prepared to provide personal information such as their contact information and Social Security number. They may also be asked to link their bank account to the lender so that funds can be quickly deposited.

Once the loan application is approved, terms of the loan such as the amount, interest rate, repayment amount and repayment schedule will be in the loan agreement.