In a business, there comes a point in time wherein you turn to fundraising. This can be by using your personal savings, raising funds through investors, or the more common option, taking out a loan. A loan is a borrowed sum of money, the principal, to be paid back at a pre-determined maturity date, plus interest, which could be either a fixed or variable rate. Just a quick browse online and you’ll see that loans can range from a prepayment period of 1 year to as long as 10 years. While it’s not obvious yet, a one-year loan term varies greatly from a 10-year one, and you’ll soon figure out why as you continue reading the article.
Below you’ll learn all about short-term and long-term loans, their advantages and disadvantages, and specific situations wherein one is better than the other.
What is short-term credit?
Short-term credit is a type of business financing in which the principal plus interest must be paid within a year; hence the name short-term credit. This is used mainly to finance operating expenses or working capital requirements.
What are the advantages of short-term credit?
As this loan has a maximum term length of one year, the amount that can be borrowed would be much less than the amount in a long-term loan. Because of this, the application process is less strict and much quicker. With First Circle, when you apply for short-term credit, you’ll know if you’re approved within 24 hours (provided you submit complete documents).
Quick access to capital
In relation to the above, with short-term credit, the application process and release of funds takes quicker than its long-term counterpart. Funding is released immediately, so you can use the cash to pay for emergency expenses, be it paying suppliers or your employees..
Not only is the approval time faster, but with short-term credit, the documents you need to submit would be much less versus if you applied for a long-term loan. This is because you aren’t borrowing an incredibly large amount (in related to a long-term loan) which equates to less risk for the lender. As there is less risk involved with short-term credit, the lender will not enact provisions (e.g. salary caps, approval or rejections of business expenses/projects) nor keep a close eye on your business which could limit decision making.
What are the disadvantages of short-term credit?
As short-term credit provides quick, efficient access to capital, the interest rates are higher. However, as with a previous article, low-interest rates aren’t always the best option. If you need to fulfill deliveries and orders to generate sales, wouldn’t you take out a short-term loan at a high-interest rate rather than not take out a loan and have zero sales because you didn’t have the capital? When making a business decision, it’s important to assess the situation, as no two situations are exactly alike.
Can open a cycle of repeated borrowing
As the application process is quick and you get the financing immediately, short-term credit is a quick solution that may be too easy if you get used to it, and you may fall into a cycle of repeated borrowing. If you take out a short-term loan this month to pay suppliers and take out another one next month to pay your employees, this is a sign that your business isn’t operating efficiently. Don’t take out short-term financing on a regular basis because you will become dependent on it which is bad for your business.
Unsustainable in the long run
As mentioned above, becoming dependent on short-term credit is bad for business because this is unsustainable in the long run. The goal of any business is profit. If you are taking out loans regularly because your revenues cannot cover your expenses, then you are not making any profit.
When should you get short-term credit?
You need cash fast
Short-term credit can be considered as an emergency fund, provided you have the means to pay the loan back. As the application process and waiting time is quick, this would be the most efficient means to get financing versus pitching to investors or applying for a longer-term loan.
Your need to borrow won’t extend past a year
You pay your employees fortnightly and purchase supplies regularly. Purchasing property to expand the business or funding a research and development (R&D) project can take years. Do you see the difference between short- and long-term needs? If you need the loan to fund a business expense that won’t last past a year, then short-term credit (versus long-term) is the best option for you.
You can control your spending
Opt for short-term credit, provided the situation calls for it, if you can control your spending. As mentioned above, the funding is released almost immediately for short-term credit. It’s quick, easy cash, and money that is received with less effort may be spent quicker than money you worked hard to earn. If you can’t control your spending, you may open up a cycle of repeated and unsustainable borrowing with short-term credit.
Now that you know the basics of short-term credit, it’s time to move on to long-term loans. Below are the advantages and disadvantages and specific situations to help you determine if you need short- or long-term business financing.
What are long-term loans?
Long-term loans are a type of business financing in which the maturity date of the loan extends past a year and can even last for as long as 20 years (e.g. commercial property loans). This is used mainly to finance long-term projects such as business expansion, franchising, purchase of property, plant, and equipment and other fixed assets.
What are the advantages of long-term loans?
Longer repayment period
With a longer repayment period, you’re not as pressured to pay back the entire loan amount quickly; however, this doesn’t mean that you should push your monthly payments to the back of your head. As this is a long-term expense, you still need to have a plan to tackle the debt.
Lower interest rates
Long-term loans usually have lower interest rates than short-term debts. This is because the application for long-term financing is much more stringent because more risk is involved being that more money is involved as well; however, as you’ll find out later, you’ll spend more on interest with long-term loans.
Can fund big-ticket expenses
The goal of any business is profits, and with that, comes the ability to scale or grow. When you started out your business, you wore many hats; you did finance, marketing, sales, purchasing, and what have you; however, as your business grows, a point in time will come wherein you’ll have to hire people and your basement or garage is unsustainable to call your office. The more your business scales, expenses are bound to crop up, and some of them will be expensive. If you have a need to automate the production of your product, you’ll need to purchase the machinery. What if you need multiple machines? This can come with a hefty price tag. Enter long-term loans, they can fund big-ticket expenses such as funding a property purchase to call your new office.
What are the disadvantages of long-term loans?
You pay more in total interest
Even if the interest rates are lower with long-term loans, you still pay more in interest because the amount you borrowed is greater than the amount that can be provided with short-term financing; however, as explained earlier, you have to assess the individual situation. Yes, you may be paying more in total interest, but if the expense is an investment and will lead to more sales (e.g. purchasing machines to produce more units faster), then a long-term loan is the obvious choice versus not taking out a loan at all.
Restricts monthly cash flow
This is very much related to one of the advantages of long-term loans – you have a longer repayment period. While you have more time to pay the loan back, it’s still highly advisable to make regular payments, as you don’t want to spend more on interest. By paying your loan regularly, this can restrict your cash flow, and imagine, if your loan term is 10 years, then that’s 120 months of paying debt versus a short-term loan, wherein after 12 months, the money you used to allocate to the loan can now be used for other aspects of the business.
More stringent application process
As amounts for longer-term loans are much larger than the amounts provided by short-term credit, there is more risk involved for lenders. To minimise their risk, the application process is stringent so as to weed out those who they believe do not have the credit history or capacity to pay the loan back.
When should you get long-term loans?
Your business is credit-worthy
As mentioned above, long-term loans are more accessible to businesses who have proven their worth. They could’ve proven their worth by being in operation for multiple years, increasing sales, and having sufficient cash reserves which are characteristic to larger ventures. As lenders want to minimise risk, they will lend to those who have the ability and history to pay back. Smaller businesses and start-ups are at a disadvantage with long-term loans because they do not have the history or credibility yet as they are only starting out.
Your need to borrow extends past a year
If you’re applying for a loan because you have project that lasts multiple years, long-terms loans is the better option compared to short-term credit. This is because long-term loans provide the amount and term period that is aligned with your purpose for borrowing. You cannot purchase real property with a short-term loan as you’ll have insufficient funds. In the same way, you can’t use a long-term loan to pay your employees’ salary for the month as you may spend the excess funds unnecessarily.
You have an actionable repayment plan for the long-term
Having debt is a burden; having long-term debt is a larger burden. If you take out a Php 15 million 10-year loan at 7% interest rate p.a., you’re paying Php 174,162.72 a month. You’ll spend around Php 5.9 million in interest. If you do not have both short- and long-term plans to pay your debt back, this could have detrimental effects on your business. Irregular payments will result to you paying more in interest, and you wouldn’t to spend any more if you’re already paying Php 5.9 million with regular payments.
Loans serve a variety of business purposes; that’s why there are short- and long-term loans. There would certainly be times in which you’d opt for short-term credit and at other times go for longer-term financing. It boils down to what your business needs given a particular situation. The sections above serve as a guide to determine the best type of loan for a given situation.