What Is Debt Financing And Is It Right For Your Business?

andresr/Getty Images: Illustration by Issiah Davis/Bankrate

Many small businesses can struggle with growth because they need access to capital. They may need an injection of cash to develop a new product, buy inventory or hire employees that will take the business to the next level. Though it might seem risky, leveraging the right type of debt funding can be a cost-effective way to seize opportunities.

According to the 2024 Small Business Credit Survey, 59 percent of employer firms applied for some kind of business financing. Forty-one percent received the full amount they applied for, while another 36 percent received partial funding. Most businesses used these funds to meet operating expenses or expand the business and pursue new opportunities.

Understanding the options and pros and cons of debt financing can help you choose the best solution for your business needs.

What is debt financing?

Debt financing is an agreement between you and a lender. The lender provides the funds you need for your business, and you agree to repay the amount borrowed, including interest, by a specific date in the future.

You can choose between short-term and long-term debt funding options. Which option is best for your business depends on how much funding you need, your business’s creditworthiness and how much time you need to repay the debt.

Types of debt financing

There are multiple types of debt financing to choose from. Consider the purpose of each loan and its terms to determine which one is best suited for your business.

• Line of credit: Much like a credit card, lines of credit allow you to withdraw money from the preset credit limit during the withdrawal period. You only pay interest on the amount withdrawn. Then, as you repay the loan, the credit limit refreshes to allow you to borrow more funds in the future.
• SBA microloan: This program provides up to $50,000 in loans, typically for small businesses that struggle to qualify for other business loans. Microloans relax eligibility requirements, such as accepting borrowers with poor credit, and many provide mentoring for additional support.
• Invoice factoring: Businesses can sell off unpaid customer invoices to invoice factoring companies for an immediate cash infusion of up to 90% of the invoices’ value. The factoring company then collects the money from your clients and pays you any remaining money after fees.
• Merchant cash advance: Companies with significant debit or credit card sales can get a cash advance on future sales. This debt funding option is easy to qualify for but has high fees.
• Business credit card: Provides revolving credit for businesses with good credit but can have high interest costs if not paid in full each month. Often has perks, such as cash rewards or introductory APRs.
• Equipment financing: Provides funding for businesses needing large equipment, like semi trucks or contracting equipment. The equipment backs the loan as collateral, acting as security for the loan. Because of this, lenders may accept businesses with less-than-perfect credit for this type of loan.
• Commercial real estate loan: Provides funding for business real estate purchases with high loan amounts and long-term repayment options.
• Term loan: Offers a lump sum of money to use for a specific purchase. This loan is repaid over a specified term, often from six months to 10 years. Startups and established businesses needing to make a single large purchase may qualify for a term loan.

Pros and cons of debt financing

Pros of debt financing

• The business retains ownership control
• Interest is tax-deductible
• Helps establish or build business credit
• Can be affordable for well-qualified applicants

Cons of debt financing

• Interest and fees could be costly for businesses with poor credit
• Could be costly for businesses with poor credit
• Collateral is usually required for the best repayment terms
• You’re responsible for repaying the loan with business assets even if you default

How to choose the right debt financing for your business

When choosing to apply for debt financing, follow these steps to find the right funding for your business:

1. Determine how much funding you need.
2. Consider how much you can afford to pay for the business loan. Use a business loan calculator to estimate the monthly repayments.
3. Decide which type of business loan best serves the purpose for which you need the funding.
4. Determine how fast you need funding. Online loans can often fund within 24 to 48 hours, while you may wait a few days to a week to get funding from a bank.
5. Research lenders and their qualifications for getting financing.
6. If possible, prequalify with multiple lenders to see the loan offers upfront. Look for the loan with the features you need with the most affordable rates and fees.

Alternatives to debt financing

Although taking out a business loan is a common way to get funding, it’s not the only option. There are debt financing alternatives you may want to consider:

• Small business grants: Grants offer free funding for your business that you don’t have to repay. It’s an attractive option especially for startups or businesses who can’t afford debt financing. But you will have to compete with many other businesses, and you’re not guaranteed to win the grant. 
• Crowdfunding: Crowdfunding allows you to raise capital for your business through donations from multiple individuals. You can either raise funding that you don’t have to repay, or you can use debt crowdfunding which raises funding in which you repay investors with interest.
• Equity financing: Equity financing involves selling shares of your business to investors who, in return, put in capital to grow your company. You can get equity financing through venture capital firms or angel investors, individuals who invest in your business. Investors will often want some control over the business to help it succeed.

The bottom line

Some businesses determine debt financing as the best solution to grow their business. Before deciding which type of debt financing is right, determine the purpose of the funding and identify the type of funding that can best serve that need. Also, consider how much funding you need and the payment amount you can afford. By researching and understanding your budget needs and goals, you can find the right debt funding option to help you turn a small investment into a significant business asset.

Frequently asked questions about debt financing

• What are examples of debt financing?

  Some examples of debt financing include short-term and long-term loans, equipment financing, invoice factoring, SBA loans, business credit cards or lines of credit.

• Is debt financing the same as a loan?

  Debt financing is another term for a business loan, referring to borrowing money that must be repaid with interest.

• What is the main benefit of debt financing?

  The main benefit of debt financing is getting the working capital your business needs to grow. Most types of debt funding provide a lump sum, which companies can use to buy inventory, real estate, equipment or to hire employees. Rather than waiting to build enough capital from revenue, businesses can seize opportunities for faster growth by borrowing money.