Q. I need some money for my small business. I have been approached by a company that will lend me the $50,000 I need. They only want to charge me 3%. I have to pay them back in one month, but as long as I pay my 3% interest on time, there will be no problem extending the loan for additional months. Do you think that accepting this loan is a good idea?
A. Probably not, but let’s explore the situation further. First, you say that they want to charge you only 3%, but that may be a bit deceptive. We suspect it’s actually 3% per month. In other words, if you borrow $50,000 for one month, you must repay $51,500 ($50,000 of principal plus $1,500 of interest). $1,500 divided by $50,000 equals 3%.
You say that it is no problem to get your loan extended for an additional month. If you do that for a year (12 times), you would pay $18,000 in interest (12 times $1,500). However, $18,000 divided by $50,000 is 36%. Therefore, even if you only keep the loan for one month, you are paying an interest rate that is 36% per year. Of course, you’ll never hear one of these lenders say that they are charging you 36%. That rate doesn’t sound good, does it? Nevertheless, that’s what it is. You wouldn’t dream of paying that interest rate for a home loan or a car loan. In fact, most credit cards offer better rates.
The loan you are contemplating is very expensive. In short, almost any other loan you could get would cost you less than the option you’ve described. You could take a second mortgage on your home, refinance your automobile, apply for a new credit card or ask your Uncle John for a loan. Explore all of the other options before taking this loan—it’s probable that any other option would cost you less, most would cost much less.
Another option would be to bring money into your business by taking on a partner—an angel investor. Sell part of your business to an investor to get the money you need. The popular show Shark Tank shows people trying to do this each week. If you follow this route, there are many precautions you should take, but that’s another topic.
Suppose you have no other options. There are no viable investors. You don’t own a home. Your car loans are maxed out and your credit isn’t the best so credit card companies aren’t interested. If you literally have no other options, the loan you are considering might make sense. The key question is how long will you need to borrow the money?
If you will need money for the long term and there is no other source of capital, our best advice is to close down your business. Essentially no legal enterprise can deliver a return of more than 36% in the long run. If your business doesn’t deliver more than your cost of capital, you will eventually go out of business anyway. Facing that fact now will allow you to cut your losses.
On the other hand, if you truly need the money, for only a short time, it may be that such a loan will make sense. For example, you owe your suppliers money. They are refusing to provide the material you need to work until they are paid. Customers owe you money for work you have previously done. What you are owed is enough to cover your obligations and you believe that you will receive payment in the near future. In this case, a short-term loan, even at a very high interest rate may make sense because it allows you to keep working.
Be cautious, there are many lenders that that prey on small business people who have a dream, but are not financially sophisticated. In some cases, the rates are usury. Accepting such rates will cause you to dig a deeper hole in the long run. Nevertheless, there may be situations where these loans are appropriate.