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And while most people would universally agree that lower cost debt is better than higher cost debt, both end up having their place and purpose.
Low cost debt financing is reserved for low risk applications.
As the risk goes up, so does the cost of borrowing.
Pretty basic, right?
There is a twist however.
Most of the lower cost capital available for small business financing is based on personal net worth, personal credit, and income sources outside of the business.
So even though a business application of financing could be considered high risk, the business owner or manager may still be able to secure low interest rates based on their personal assets and income.
This creates the illusion that low interest rates are available for all small business applications, regardless of their size and relative risk.
Here's where the trap comes in.
As the business grows, it will use up all the low cost financing leveraged from personal assets and will need to factor in higher cost small business financing sources to fund the capital requirements of the business.
At this point, the risk of the underlying business now starts to get reflected in the interest rates.
The problem is that hardly anyone ever plans for this to happen and the business leap frogs from low interest rate personal loans disguised as business loans into high interest rate personal credit cards.
If the business achieves short term profitability, there can still be low and medium range interest rate products available to fund growth.
But if the business startup period drags on, which is not at all uncommon, higher cost personal financing can quickly become the only capital available to cover short term losses and/or larger than expected start up costs.
To avoid falling into the low interest rate trap, consider the following steps when constructing your small business financing strategy.
>>> Be Ultra Conservative When Estimating Your Capital Requirements.
When you're trying to start up a business, its all about being optimistic and getting things going so that you can make all kinds of money. Right?
In the excitement of planning a new venture its easy to delude yourself as to what the business start up is realistically going to cost to get going and become profitable.
A better approach is to be conservative with your small business financing requirements, factoring in all probable costs in more detail to increase accuracy.
Even if you think you're being ultra conservative with your capital estimates, add another 20% to whatever number you come up with as a contingency fund.
Things can and will go wrong.
The perfect startup scenario is about the same odds as winning a lottery ticket, so you might as well go play your lucky numbers instead of banking on an overly aggressive small business financing plan.
>>> Understand The Limits and Criteria For Low Interest Rate Financing.
For startups, low interest rate financing comes from personal credit and government sponsored programs.
In either case, there are limits as to how much capital you can acquire.
The limits for government programs are normally well defined. Just don't automatically assume that you qualify for the maximum amount.
Personal limits are going to be based on a combination of your credit score, your liquidat-ible personal assets, and the cash flow available to service the debt.
Short term profitability in the business will provide you with greater access to small business financing, but at a slightly higher interest rate compared to low cost personal financing.
The interest cost of incremental capital will continue to rise if the additional debt is not matched by corresponding amount of personal or business equity.
>>> Factor In The True Cost Of Borrowing
When creating your small business financing projections, make sure that you accurately estimate your cost of borrowed capital.
If your low cost money sources are not sufficient to cover off your capital requirements, then factor in higher cost sources available to you and see if the cash flow projections still work.
There is no value in creating an unrealistic cash flow projection.
It can only lead to poor business decisions which will not keep you in business very long.
If the cash flow numbers don't add up, avoid the temptation to reduce your capital requirements or lower the average cost of capital just to make the numbers work.
The reality of good numbers may tell you not to proceed with your plans, which could very well be the best business decision you ever make.
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