Imagine your business is so financially strapped that in order to pay off your creditors, you have to take another loan, from another creditor. At this point, you are paying off interest while racking up more interest. A business can not stay afloat for long in this type of situation.
Unfortunately, I’ve seen situations like this in real life, with real businesses and real finances at stake. Many don’t realize they are in deep, turbulent water until they start to sink. What’s more, I’ve seen businesses receive financial advice that would have been a life preserver, keeping them afloat in the choppy waters long enough to pull them to shore. Instead, they took hold of the more comfortable, quicker “solution”, which weighed them down like an anchor. Instead of floating, their business became perilously close to going under.
Short term lenders, or predatory lenders, feed off of struggling businesses by providing a short term solution that causes bigger and longer-term issues, often not realized until after the loan has been accepted.
If you find yourself in need of “fast cash” and are considering taking a loan from a short-term lender, I’d love to be your life preserver! Contact me first for the true understanding of what you’ll be paying, and to review other options that might be available to you. If you had all of the facts – would you grab the anchor or the life preserver?
How Predatory Lenders Sink Businesses
Predatory lenders are really great at making their offers look shiny: get money quickly, with “low interest” and few fees, and minimal paperwork. They prey on business owners who need cash fast but don’t truly understand the accounting and math that goes into how they calculate loan payments. A lot can hide in the numbers when you don’t understand them.
Here’s the scoop: Short term business loans usually have weekly payments and a variety of fees that “hide” the true cost of the loan. Once you add up all these weekly “fees” on top of the interest, the true potential interest is 20-50%, even though they advertise much lower rates. I’ve actually seen a business that was paying 91% of their original loan amount in interest and fees!
Short term lenders also won’t provide you with a true amortization schedule, which means it’s even harder to figure out how much you are paying towards the principal on each payment. Keeping your books and accounting statements in order can quickly become a mind-boggling puzzle with the way they do their “math.”
Alternatives to Predatory Lenders
Instead of securing a short term loan that could sink your business’ finances, it’s better to first talk with your bank about a line of credit. Taking out a 3- to 5-year loan is also a great option, and you can always pay it back faster if you have the cash available.
Another alternative is a government loan. These have become more popular since the COVID-19 pandemic, and more loans are available to small businesses who need help. Check out the SBA’s website to learn about your options.
Depending on your situation, it may be difficult to get approved for a legitimate loan, but keep looking and ask financial experts to help. There are plenty of trustworthy resources available to you.
Understanding and Properly Managing Your Loan Cash Flow
Regardless of the type of loan you end up getting, it’s important to record your loans and loan payments properly in your books. It’s equally as important to understand the accounting behind this process so you aren’t surprised by anything during the loan period.
When you have a properly, fully-amortized term loan, you are paying a fixed monthly payment for the entire life of the loan. But in reality your payment is broken up into two parts: one piece is paying interest and the other piece is paying the principal. Just how mortgages and car loan payments work, the same is true for business loans. The amount of money going to principal increases with every payment, and the amount going to interest decreases with every payment. At the beginning for the loan, you are paying more interest than principal. At the end of the loan, you are paying more principal than interest. This is important because it affects the amount you can deduct on your tax return each year.
You should list interest as an expense on your Profit and Loss statement. Your principal is recorded as a reduction in the loan balance, which is in the liability section of your balance sheet. So, how do you know what to record as interest and as principal when you are paying a fixed payment each month?
The first step is to get an amortization schedule from your lender. This will show you the breakdown of interest and principal payments every month so that you – or your bookkeeper – can record it correctly.
If your lender does not supply an amortization schedule for you, I am happy to prepare one for you. Utilizing the proper financial tools will set your business up for success in the long-term, and will also help avoid unnecessary bumps in the road in the short-term.
For example, if you record your entire monthly payment on your P&L, your tax preparer will make an adjustment at the end of the year, which changes your net income. Before the adjustment is made, your Profit and Loss looks worse than it really is. Your tax preparer will remove the proper principal amount, making your net income go up. Your net income looks better, but better net income means you have to pay more in taxes, too. This isn’t usually a happy surprise, and can be avoided by understanding the process fully from the beginning.
Depending on how big your loan is, and if you are at the beginning or end of your loan period, your taxes may increase only a little, or quite a bit. This adjustment is usually where business owners start feeling strapped for cash because they see how much they owe in taxes. Unfortunately, they start looking for short-term lending options to help (psssttt…don’t do that!!).
Huxley CPA Can Help
If you are considering taking a short-term loan, or need help wrapping your head around the loan cash flow & accounting process, Huxley CPA is ready to be your life preserver. Contact me to discuss customized advising to understand your business’ finances and the best options that will set you up for success. If you have all of the information in front of you before making a big financial decision, my money is on you grabbing the life preserver, not the anchor.