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Advantages and disadvantages of working capital loans
by
Irene Scott
October 2, 2023
Verified by
Jonah Collins
Many or all of the products featured here are from our partners who compensate us. This may influence which products we write about and where and how the product appears on a page. However, this does not influence our evaluations. Our opinions are our own. Here's how we make money.
Working capital loans allow businesses to borrow money to cover cash flow shortfalls and pay for day-to-day expenses, such as salaries or stock purchases. Even the most profitable businesses can have cash flow problems, which working capital loans help alleviate.
Although working capital loans can help a business make ends meet, there are drawbacks to consider before abusing them.
What is a working capital loan?
A working capital loan is a type of short-term business loan. Applications and financing are usually quick and allow businesses to borrow money to meet immediate needs, such as paying rent or salaries. The repayment period is usually short, not exceeding one or two years.
Businesses that lack sufficient cash to pay day-to-day operating costs can turn to working capital loans to make up the difference.
Types of working capital loans
There are several types of working capital loans, including term loans and business lines of credit. Each works slightly differently and is designed for different purposes. Knowing what is right for your situation can help you find the best loan.
- Term loans: traditional loans with an initial lump sum and regular payments over the following weeks, months or years.
- SBA loans: large loans insured by the Small Business Administration. Approval may take longer, but loan limits are much higher.
- Lines of credit: Flexible lines of credit allow you to draw money in installments as needed. You pay only interest on the current balance of the line of credit.
- Business credit card: flexible credit lines designed for everyday purchases. No interest is charged if the balance is repaid each month.
- Invoice financing/factoring: financing secured by the value of unpaid invoices. A percentage of what is owed can be obtained immediately, with automatic repayment when customers pay the invoice.
- Merchant cash advance: these are small quick loans for stock purchases or small immediate expenses. Payment is made automatically by sending a percentage of future sales to the lender.
Advantages of working capital loans
Working capital loans have a number of advantages that make them a popular choice for businesses in need of financial flexibility.
Rapid financing
Because working capital loans are intended to pay day-to-day operating expenses, lenders prefer fast approval and funding times. This is especially true for online lenders, who can often approve the application in minutes and have the money in the company's bank account the next day.
Possibility of being unsecured
Many working capital loans do not require collateral, thus reducing the risk to the borrower. In addition, the application process is simpler, as there is no need to wait for the lender to evaluate the collateral and ensure that it is of sufficient value to secure the loan.
Less stringent eligibility requirements
Most lenders, particularly online lenders, are relaxing eligibility requirements for working capital loans. This makes them more accessible to start-ups and business owners with poor credit, who generally have difficulty obtaining financing from traditional lenders such as banks and credit unions.
Disadvantages of working capital loans
The best short-term business loans can be useful when a company needs quick liquidity, but there are some important disadvantages to consider.
Lower loan amount
The amount that can be borrowed with a quick working capital loan is usually much lower than with long-term loans or loans that involve a more complex underwriting process.
For example, many online lenders that specialize in quick working capital loans set limits of $100,000 or $250,000 for term loans and business lines of credit. These limits are much lower than the $500,000-plus limits offered by banks.
Short repayment terms
Working capital loans are intended for short-term use, so lenders expect to be repaid relatively quickly. Many working capital loans have repayment terms of 18 months or less, particularly those made by lenders working with entrepreneurs with poor or weak creditworthiness.
Sometimes it is possible to find working capital loans with repayment terms of two years or more. This is the case with lenders such as SMB Compass, which offers bridging loans of up to 36 months.
Frequent payments
With most loans, you can expect to receive an invoice once a month and make payments once a month. With working capital loans, this schedule can be accelerated. Many lenders require biweekly, weekly or even daily payments, depending on the terms of the loan.
If you already have cash flow problems, the need to make frequent payments can make matters worse. If you are not careful, you risk defaulting on your loan or getting into heavy debt.
Higher costs
Because working capital loans are approved quickly and have less stringent requirements than other loans, many lenders charge higher rates and fees. Some alternative high-risk loans, such as invoice factoring, merchant cash advances, and lines of credit opened to contractors with bad credit, may use factoring rates instead of interest rates. Factoring rates are expressed in decimals, usually 1.1 to 1.6, and can be an expensive form of lending if care is not taken.
Before taking out a loan using factoring rates, be sure to convert them to interest rates so you can compare them with other loans and better understand the cost. Our guide to factoring rates will show you how to do this.
Working capital loans can help struggling businesses find the funds they need to pay for day-to-day operating costs. Quick approval and simple eligibility requirements make them an easy way to get a loan. If you decide that a working capital loan is right for you, choose the right type of loan and look for the best deal.
Frequently asked questions
Does the SBA offer working capital loans?
Yes, the SBA offers working capital loans. You can use the organization's CAPLine or SBA Express loans to cover your working capital needs.
What credit score is required to obtain working capital?
Each lending institution sets its own requirements for obtaining a loan. In general, online lenders have lower requirements than banks or credit unions, and you may qualify with a score of 600 or even lower. However, a low credit score means high borrowing costs.
What are the benefits of a working capital loan?
Working capital loans are used to cover short-term borrowing needs. They offer many advantages, including quick approvals and funding, simple loan applications, and less stringent eligibility requirements than other types of business loans.
