What is Debt Financing?
When you think about debt, you may consider loans with fixed terms and payments. Debt financing is a type of funding that will require your company to pay back the borrowed funds over time.
The amount of money that your business borrows (and must then repay) is generally referred to as the principal. The borrower must also pay interest on the principal amount, which is how the lender makes money from lending out funds. This interest rate applies during the length of the term of the loan, which can be anywhere from six months to 30 years depending on what kind of debt financing you are using (more on this in a bit).
Lastly, most lenders will require some form of collateral for larger loans or when giving out unsecured loans, which means that borrowers must offer up some form of asset (real estate or equipment are common examples) as security for the loan in case they can’t repay it.
How does debt financing differ from equity funding?
Equity financing is different from debt financing because it requires you to give up ownership in your business when you take on equity investors. The opposite is true of debt—you will still own your entire company, but now you will have a loan that must be paid back with interest.
What are the key benefits of debt financing?
1. Business Ownership remains with you
When you take out a loan from a financial institution or an alternative lender, you are only responsible for making timely payments for the duration of the loan. If you give up equity in the form of shares in return for finance, on the other hand, you may be dissatisfied with outside advice on the future of your company.
2. Tax Deductions
A strong advantage of debt financing is the tax deductions. Classified as a business expense, the principal and interest payment on that debt may be deducted from your business income taxes.
3. Easier Planning
When you know how much principal and interest you have to pay, it becomes easier to plan out your budget for each month.
Cons of Debt Financing
1. You must repay the debt.
This might seem obvious, but it bears mentioning here because it's one of the foremost drawbacks to taking out a loan as opposed to another form of small business financing. If you need money quickly and you know for sure that you can pay it back without fail, then this drawback won't be much of an issue for your company. But if you're still figuring out whether or not your business will succeed (or dealing with seasonal cash flow issues), then having to borrow money could put unnecessary stress on your finances.
2. You must continue meeting the terms of the loan agreement
You must continue meeting the terms of the loan agreement even if things go south with your business. This drawback is related to the first one—you're still on the hook for repaying that loan, even if it fails entirely and leaves you destitute and penniless (okay, maybe not destitute and penniless).
3. You must pay debts regardless if they make sense or not.
There are times when companies spend too much on equipment or hire too many employees because they have all this extra cash lying around from their loans! However, sometimes these decisions come back to haunt them when they run into financial difficulty later on.
Alternatives to Debt Financing
It's always good not to be in debt, but there are times when it makes sense to go that way. One of those times is if you make a lot of money and want to invest some of it. Or if someone gives you money and you need a way to pay back the loan later with less interest than paying back the entire amount over time. Or if you're just starting out and can't borrow enough money from banks or other lenders.
And then there are bad loans: loans that have gone bad, even though they were probably great at one point. So there are lots of reasons why people get into debt and then stay in debt. But there are ways out, too, whether it's by using debt financing or going without a car or house for awhile so you can see how much it really costs to live your life on a budget
Entrepreneurship
