The cycle of debt…While we work with vendors to get them working capital loans, we also advise on the best ways to manage business…ensuring you know how to get out of the cycle of debt is an important lesson.
Members of the Armada team often attend events sponsored by our capital equipment vendor partners. These events are usually first-class affairs, and customers walk away with a wealth of knowledge to help with technical aspects of operating their equipment as well as pointers about managing their businesses. This includes ensuring how clients don’t enter that infinite cycle of debt that we explain in this article.
We frequently have the honor of addressing customers to talk about the cost/benefit of the various ways of financing capital equipment. One of our most popular sessions is “The Endless Cycle of Debt.” To get the full impact of the discussion, you would really have to attend of these events in person to see me flailing my arms, using my Rasputin-like facial expression, and instructing my partner, Dan, to click to the next slide. But I think I can do it justice in a brief blog.
Business decision-makers often look for the lowest cost alternative. This sometimes influences which capital equipment they will buy, which is an entirely different discussion and a topic for a different blog. I want to talk to you about whether the lowest interest rate financing offer is your best alternative in every situation – assuming you have already decided on what equipment, manufacturer, brand, model and specifications.
Consider all the costs, not just interest rates.
You should consider all the costs, and not simply the interest rate. Additional factors that impact your cost of borrowing include:
- Upfront and continuing fees, such as a commitment fee, administrative fees, annual review and renewal charges, additional services you will be required to use to access the financing, etc.
- Other transaction costs, like if you will need to hire a lawyer to complete your financing transaction, report to the lender monthly or quarterly or provide a higher level of assurance on your financial disclosure.
- The term of your transaction. A longer-term will necessarily increase your overall borrowing cost.
All that is important, but there is one trap that snares a lot of smart business owners. I call it the Infinite Cycle of Debt. I refer to it as a “trap” because most people do not see it coming until they are stuck in the cycle. Lenders make it easy for their consumer and commercial customers to access credit at seemingly low rates. The lenders benefit because they benefit from their customers being “hooked” on debt.
A Closer Look at The Infinite Cycle of Debt
Let’s explain this by looking at a typical example:
Sally starts a business. She has great personal credit, excellent experience, and a terrific business plan. So she qualifies for a small line of credit with her local bank and a couple of low rate credit cards. In many instances, a small business owner will have to put up the equity in their home to qualify for a bank loan for their business. (By the way, Armada finances many start-up businesses who do not qualify for nay any bank lending. That’s a subject for yet another blog.) Sally uses part of the proceeds of her loan to build out her premises and buy inventory. She uses the credit cards to buy supplies for the business and a couple of times takes cash advances.
To preserve cash to finance the business, Sally makes minimum payments under the bank line and credit cards. She is mostly paying interest, and hardly makes a dent in the principal. She might even get another credit card to give her more borrowing capacity. Depending on cash flow, some months the principal balance increases because she has not paid off the entire amount of the interest that accrued.
But Sally is smart and resourceful. She uses her line of credit to pay down the higher interest credit card balances. As she approaches the credit limit of her line, Sally might get another credit card and even a second line of credit with a cash-flow lender or a merchant cash advance. Although cash-flow lenders make it difficult for their customer to determine their actual borrowing costs, the all-in cost of most cash-flow loans is substantially higher than credit card rates of interest. We recommend that such sources of “alternative” credit only be used in emergencies or to take advantage of extremely lucrative opportunities.
At this point, Sally’s business is paying interest on interest and she has lost track of her true cost of capital. That line of credit where the interest rate is only Prime + 2% actually ended up costing a lot more.
So what should Sally have done? We have been involved in equipment financing for a long time. That’s because we believe what we do is an important piece of a balanced treasury strategy. There is a place for business credit cards and lines of credit in addition to capital equipment financing – usually to finance working capital costs or investments that will appreciate in value. Equipment financing is suited to acquiring assets that will generate revenues and/or reduce costs but whose value will also depreciate over time. The best time to finance equipment is when you first acquire it because that is when the value is highest. Even though the “rate” for a lease or secured loan might be slightly higher than for a bank line of credit, the scheduled regular payments will help most businesses stay on track and pay for their equipment sooner. That often results in lowering the overall cost of borrowing, reducing the strain on the business from carrying debt, and having greater predictability around cash flow.
Break The Cycle of Debt
The Armada team is passionate about helping our customers grow sustainable and profitable businesses. If you would like to learn more about how you can avoid the Infinite Cycle of Debt, then please call to speak with one of our equipment finance experts.
Contact us today and let us help you with your working capital loans, financing, and ensuring you escape the Infinite Cycle of Debt.