When running a small business, every penny matters. In today’s economy, it’s easy to see how small business owners are struggling financially. They have to handle ongoing expenses, fluctuating profits, and more. For many of them, a fast money infusion can solve a lot of problems. But when you have less than stellar credit, where can people turn? Some turn to a business cash advance for bad credit.
One of the most common ways to get the help you need is a business cash advance. In this article, we’ll look at the types of business cash advance options available. We’ll also explore what you need to know about choosing the one that’s right for you and your business.
Do You Have Bad Credit?
Before you consider bad credit business loans or a merchant cash advance, you must understand where you stand financially. To do that, you need to understand your credit report and your credit score fully. A credit score is a rating of how well you repay loans and lines of credit. Financial institutions, retailers, utility companies, and many other businesses use this score to determine the risk of lending to you.
Your credit score is a part of your credit report. The credit report is a detailed summary of your relationship with money and your creditors, both past and present. Credit bureaus issue these credit scores to determine small business loan amounts, down payments, and interest rates. The three major credit bureaus in the United States are Equifax, Experian, and TransUnion.
You can access your credit report through each of the three major credit bureaus’ websites or by using one of many online credit management sites, like creditsesame.com. It would help if you never had to pay to see your credit score or credit report. Luckily, the law requires credit bureaus to make them available at no cost.
Let’s take a look at the elements of your spending habits that make up your credit score, along with the weight of their impact:
Payment History (35%)
Payment history is the list of records of all payments you make to creditors or other businesses. As a result, potential lenders can see how you repay the money you borrow and if you do so on time. Bad payment history will quickly jeopardize your credit score. Your payment history has the most impact of all five determining factors, accounting for 35 percent of your credit score. That’s why we always remind you to pay your bills on time. It truly matters.
Credit Utilization (30%)
Credit utilization is the percentage of how much of your available credit you are using. For example, if you have a balance of $200 on a credit card with a $1,000 limit, then your credit utilization would be 20 percent. If you don’t want to hurt your credit score, keep it at 25 percent or lower. Credit utilization accounts for 30 percent of your score.
Credit History (15%)
Long credit history is evidence of responsible credit management over a long period. Showing creditors that you’ve been consistent with your accounts will tell them that you’re trustworthy and will likely continue to be. Credit history makes up 15 percent of your credit score.
New Credit (10%)
The number of new accounts opened in a short period affects your credit score. Opening several accounts at once could contribute to a bad credit score because it may look to a lender that you are in some bad financial situation. New credit accounts have a 10 percent effect on your credit score.
Credit Mix (10%)
The variety of credit accounts you have is known as your credit mix. An ideal combination would be managing car loans and credit cards because they are repaid in different ways, showing creditors that you can manage another small business loan or line of credit. However, your credit mix will only make up about 10 percent of your credit score; the other factors that look at your spending and bill-paying habits will be weighed much heavier.
The credit bureaus evaluate all those factors and calculate your credit score—a three-digit number ranging from 300-850:
300–499 Very Poor/Bad Credit
500–600 Poor/Bad Credit
601–660 Fair Credit
661–780 Good Credit
781–850 Excellent Credit
About 20% of Americans have bad credit. There are bad credit business loans available, but they give borrowers the same challenges as any other bad credit loans: High-interest rates and tight loan terms. For some small businesses, taking on traditionally structured lousy credit loans may not be the best move, as they may not be able to count on steady revenue to repay the small business loan. Instead, let’s look at one popular option that can provide upfront cash with a more flexible repayment plan: The merchant cash advance.
A merchant cash advance can be an excellent solution for small business owners looking for an alternative way to finance their businesses, especially those who have bad credit.
Merchant Cash Advances
A merchant cash advance is a form of short-term financing that will quickly provide you with the funds you need. It could be a good solution for your small business if you need cash flow or working capital. These funding options are primarily provided by banks and financing institutions that offer credit or debit credit card processing. Did you know that businesses are charged every time you swipe a card at their establishment? A merchant cash advance is repaid with those swipes, plus fees and interest.
Merchant cash advances allow you to get money upfront while paying back a percentage of your daily credit card and debit card sales plus an additional fee.
A merchant cash advance is not a small business loan because it’s a sale of future revenue. Because of that, it’s not subjected to the regulations imposed on a standard small business loan. Instead, you are selling a portion of your future sales. That means that you can get an MCA without using any of your assets as collateral. Instead, the MCA financing company takes a lien against all (or most) of your company’s earnings until they are repaid.
How Do They Work?
A merchant cash advance is a way for businesses to get the funds they need without using equity or taking on a small business loan. Traditionally, these options have been for companies that receive revenue primarily from credit and debit card sales. But now, this financing option is becoming more widely used. For example, if you are a retailer who generates most of your revenue from an in-store experience, a merchant cash advance could work for you as well.
Merchant Cash Advances can be repaid in two ways. First, a borrower can either contribute a portion of their future credit and debit card sales through their merchant account. They can also pay weekly or daily fixed installments through automated bank withdrawals.
When repaying a merchant cash advance in fixed installments, borrowers are charged according to their ability to repay the advance. Merchant cash advance assesses risks by assigning each borrower a determinant called a “factor rate” that ranges between 1.2 and 1.5, depending on your level of bad credit and the stability of your business.
Some of the following factors determine factor rates:
Credit Card Processing Statements
One of the requirements for getting a merchant cash advance is to show proof of a substantial history of successful credit card sales. The best way to do this is by providing them with statements from the last three months.
Business Bank Statements
The financing company will want to be sure the owner’s business is in excellent financial condition. A borrower should be ready to present bank statements from the past three months.
Business Tax Returns
Recent business tax returns will give a financing company an idea of how the business financially shapes up over a year.
Number of Years in Business
Most financing companies require you to be in business for at least one year before they will consider giving you a cash advance. Older, established businesses can get more favorable factor rates.
The lower your factor rate, the lower the price of your merchant cash advance. A borrower can then use the factor rate to determine how much their merchant cash advance will genuinely cost them.
Let’s take a look at how factor rates work. Suppose you are a business owner who is getting a merchant cash advance for $10,000 with a factor rate of 1.35 for a term of 12 months. To get your cost, multiply the advance amount by the factor rate. So, that means that your $10,000 merchant cash advance will cost $13,500. To a person with some knowledge of loans, the factor rate can seem like the interest rate.
When it comes to a business loan, the interest is calculated from the date of origination. This is what makes a factor rate different from an annual percentage rate (APR). APR is used for financing where interest accrues on the principal amount, even as it gets smaller due to the payments made. Anyone looking into this kind of cash advance should make sure they know the difference between these two rates because they are two different ways you are charged for the cash advance.
The biggest thing to keep in mind with a merchant cash advance is that there are many variables. For example, merchant cash advances are paid back daily, or however often you batch out your credit card system. So that means that the better you do, the higher your installment payment will be.
How To Apply For a Merchant Cash Advance
Getting cash advances is relatively easy, and they have very high approval rates. Usually, all you need to submit is an application, a government ID, and a few months of business bank statements. However, keep in mind that some funding companies may ask for additional documentation outside of these, so be sure to check with each financing company about their specific requirements.
Cash Advance vs. Small Business Loan: What’s The Difference?
While merchant cash advances and business loans are both available to people with bad credit, they are not the same. So let’s take a look at how they differ.
A business loan is a loan for predetermined amounts of capital that are repaid with additional interest in fixed monthly payments. Business loans have an annual percentage rate of anywhere between 3% to 10%. Small businesses loans can be drawn from banks or the federal government, typically through the Small Business Association (SBA). And it seems like small businesses are a pretty big business; according to the SBA, small business owners borrowed over 20 billion dollars in 2020 alone.
Outside of the restaurant and hospitality industries that see over half of their small business loans approved, the ability to get a small business loan is tight across all other professions. For example, a business has to make at least $50,000 in annual revenue to be considered for many loans.
And, of course, the quality of the owner’s credit is a significant factor. Banks only approve loans to individuals with a credit score of 700 or above. If your score is on the lower side of that range, stronger business credentials will be required if you want to be considered for the business loan. If you have terrible credit, bank loans aren’t a great option.
Also, you must meet the requirements of many lenders when applying for a business loan. For example, you will need a net operating income at least 1.25 times greater than current expenses, collateral, and a plan of how you will use the money to be approved.
Cash Advance Advantages
With fewer restrictions than SBA or bank loans, merchant cash advances have increased accessibility and availability than traditional avenues of financing. These options also have less strict conditions for approval, making it much easier to access the money you need. Meanwhile, small business loans are often rejected because they have more stringent requirements. The borrowing limits of each resource are also different. A business loan can be used to borrow millions of dollars, and merchant cash advances usually have a max limit of $500,000.
Merchant cash advances can undoubtedly provide financial relief for small business owners when they need it the most. But, the hard facts about these financial options—particularly their high interest rates—can make them tough to manage. As a result, many critics of merchant cash advances dub them “The payday loans for small businesses.”
While both options have their advantages and disadvantages, merchant cash advances are an easy way for merchants who use credit card processing to get cash fast. Moreover, it’s a flexible way to get the money you need without submitting collateral or waiting for approval, and there are no restrictions on how the advance is used. On the other hand, there is more freedom with MCA’s, and their high cost is the price you have to pay for their flexibility.
Will a Business Cash Advance Fix My Money Problem?
A business cash advance can provide relief now, but problems can arise almost as quickly as they were approved. When a business owner with bad credit turns to a merchant cash advance option, they are usually already in some form of financial trouble. It may be coming from the business itself—inadequate revenue and business interruptions (like a global pandemic) are just a couple of possible issues. If they fall behind on their repayment schedule and start to look like they can’t repay the advance within the approved time frame, they roll over their balance owed into a second cash advance to cover those expenses and get another small bailout. The solution is temporary, but the debt cycle that a business owner can fall into can run for a very long (and expensive) time.
Alternatives to Merchant Cash Advances
Even after careful research and consideration, you may discover that a merchant cash advance isn’t for you. Here are some other avenues to explore:
Community Development Financial Institution (CDFI)
Community Development Financial Institutions are private-sector financial institutions that focus primarily on personal lending and business development efforts in more impoverished local communities requiring revitalization. CDFIs work with local communities and provide business loans and grants that promote economic development in underserved areas. If you’re eligible for financing, you could get a competitive interest rate. Funding can be slower than online lenders, but the savings could be worth the rate. So start your CDFI research today.
Peer-to-Peer Lending (P2P)
Usually, when you apply for a loan, you request money from a bank, credit union, or some other financial institution. However, with Peer-to-Peer lending (P2P), borrowers connect with investors looking to finance loans to people without the intensity of a cash advance situation.
P2P lending is a relatively new lending option that gives people with bad credit a better chance at getting a lower interest rate on an installment loan. Conversely, traditional lenders may rely more on your credit score to decide on your loan application. P2P lenders are investors first. They are watching market behavior and consumer trends across multiple industries to make profits where they can.
The business owners who have a great product or business model—but are just short on cash—can have their work speak louder than their credit score. After all, P2P investors are in the business of making money, and if you can borrow on their terms, they can most likely work with you. If you need a little help to get back on your feet, P2P installment loans could be a great choice. The fixed monthly payment over a long period is not only helping you get out of debt faster but can also help improve your credit score, as long as the installment payments are made on time and in full.
Some of the fastest and easiest cash advances exist in the form of payday loans. But the ease of use and speed of a payday loan usually isn’t worth the high cost and hassle.
These are short-term loans that usually only last a couple of weeks on average. They can be secured with few documents and, in most cases, within the same day as the application is completed. Additionally, payday loans require no collateral. Potential borrowers only need to have an ID, a bank account, and proof of income.
A borrower will apply for a payday loan and provide banking information for automatic withdrawals and deposits or simply write a check for the amount of money they want to borrow (along with the lender’s fees and interest). If approved, the borrower gets their money, and the lender withdraws the repayments from their checking account. Payday loans can either be repaid through short installment plans throughout the loan or in a lump sum at the end of the term.
Like merchant cash advances, payday loans can be rolled over into new loan agreements to help borrowers finish paying off balances without suffering penalties. However, these loans are subject to the same processing fees and interest rates as the original loan. If you have ever heard of payday loans having ridiculously high-interest rates, it is because of this compounding effect. This means that payday loans, if not properly managed, can cost hundreds of dollars more than expected.
Cash advances can provide many benefits. However, like any financing product, they can create problems if misused. Given how these transactions are funded, consider getting financial advice from a CPA to determine if this is the right solution for your company.
If you don’t understand any terms in the financing contract for your small business, ask! When it comes to taking on a cash advance—no matter how desperate you may be—you need to know what the responsibility means in dollars and cents.