If your current small business loan isn’t meeting your needs — or you’re simply curious as to whether there’s money to be saved through another solution — refinancing a small business loan.
In most cases, this means taking out a new loan and using the newly borrowed funds to pay off one or several previously held loans through a lump-sum payment of the remaining amount owed.
But can you really save money through refinancing? Is the process overly complicated or confusing? Here’s what you need to know about refinancing a small business loan so you can save more and potentially reduce debt.
Reasons for refinancing a small business loan
Borrowers typically pursue debt refinancing to improve their borrowing situation in some way — either by saving money, gaining existing capital, changing their borrowing terms, or finding a debt financing solution that is more favorable to their circumstances. Take a closer look at these four common scenarios to determine whether refinancing your small-business loan is the right choice for you.
1. Graduating to better interest rates
In the best-case scenario, business owners who have improved their personal credit or their company’s financial standing are often able to qualify for better loan options than they were at the time of the original loan. If your business has recently hit a significant milestone — such as a two-year anniversary of operations or six figures in annual revenue — or your personal credit score has recently surpassed that magic 700, you might be ready to graduate to lower interest options.
2. Finding more favorable loan terms
When your business needs financing and options are limited, it’s easy to skip reading the fine print on your small business loan. But once you’re living with the daily reality of inconvenient loan terms, like daily payments or a very short repayment period, you might find yourself quickly searching for a better option.
If the stress of never-ending payments is taking its toll on your cash flow and your sanity, consider refinancing a small business loan to find more favorable terms.
3. Adding capital to fuel growth
Some business owners will use refinancing as a means to add capital to their original loan amount without adding a second and separate short-term loan.
Though it might not be a dramatic change, adding another $20,000 in financing — particularly when combined with extending your loan’s terms by another year or more — might give your business the extra breathing room it needs to get to that next big deal. In the meantime, it can allow you to continue building your business and personal credit to expand your future borrowing options.
4. Debt consolidation for simple financial management
So far, we’ve referred to refinancing a small business loan as paying off a single loan by taking out one other single loan. However, that’s not the only form of refinancing out there. For borrowers who currently hold more than one form of debt, loan consolidation offers the opportunity to roll up multiple daily, weekly and monthly payments into a single, more manageable loan.
Debt consolidation offers all the same advantages as normal loan refinancing, but it comes with an added bonus — replacing multiple forms of debt with a single loan will save you the headache of juggling all those payments and due dates!
Refinancing traps to avoid
Whether you’re holding onto extra hard-earned cash or merely conserving your sanity, there are plenty of ways to save money when refinancing a small business loan. That said, certain terms or circumstances can cause refinancing to actually cost you more than keeping your current loan conditions. Watch out for the following easily overlooked traps that might make refinancing the wrong choice for your business.
Since refinancing your small business loan essentially means using funds from a new form of financing to pay your original loan off ahead of schedule, you would think paying your loan early would be a good thing to a lender, right? Unfortunately, that’s not always the case.
If you pay back your loan before that interest is accumulated, they actually lose the revenue they would have earned on that loan. To avoid this loss, some lenders actually include prepayment penalties in their loan terms. Those penalties can sometimes be very steep, negating any potential savings you may have incurred through refinancing.
Before making the decision to refinance your small business loan, re-read the fine print on your existing loan to check for any prepayment penalties.
The short-term debt cycle
The other all-too-common refinancing trap we see is even more dangerous than prepayment penalties. It happens when business owners who have faced a cash flow crisis that lasted longer than expected find themselves refinancing expensive short-term debt with yet another, equally expensive, short-term loan.
Here’s why this isn’t a good idea: In the beginning stages of an expensive short-term loan, borrowers are typically incurring interest faster than they can pay it off.
As a result, when they go to refinance, business owners will actually owe more on their original loan than they took out in the first place. If you seek to refinance in that scenario, you’re essentially borrowing money with interest to pay back interest. This can become a slippery slope on a very dangerous short-term debt cycle.
There are a few limited situations in which refinancing one short-term loan with another is a necessary evil, but in most cases, this is a sign that your business has bigger financial problems to address.
Deciding when to refinance your small business debt
Under the right circumstances, refinancing your business’s existing debt has the potential to save you huge sums of money and change the game for your company’s financial forecast. But to really understand whether this is the right choice for your business, you’ll have to crunch the numbers for yourself.
Consult with a reputable lender or broker about your refinancing options, then weigh the potential savings on interest, the cost of any prepayment penalties on existing debt, and the value of any changes to your access to capital or loan terms. Once you lay out all the numbers and compare and contrast your existing loan product with your refinancing options, it will be easy to see whether refinancing a small business loan is the right decision for you.
The above content should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.