Debt financing is when you borrow money to finance your business and then pay it back to the lender (plus interest) over time. It differs from equity financing, which involves bringing in investors who provide financing in exchange for an ownership stake in your company.
Examples of debt financing include traditional bank loans, credit cards, government loans, lines of credit, and bond issues. Read on for a closer look at how debt financing works, its pros and cons, and how it compares to equity financing.
Key Points
• With debt financing, businesses borrow money without giving up ownership or equity, allowing founders to maintain control over the company.
• Businesses agree to repay the borrowed amount with interest over a set period, providing predictable, structured payments.
• Interest payments on business loans are typically tax-deductible, which can reduce the overall cost of borrowing.
• Successfully managing debt improves a business’s credit rating, potentially making it easier to secure future financing at better terms.
• Taking on debt increases financial obligations, and failure to meet repayment terms can lead to penalties, legal action, or even bankruptcy. It’s important to always make your debt payments on time each month.
What Is Debt Financing?
Debt financing is essentially borrowing money for your business from an external source. In exchange for the borrowed funds, you agree to pay back the principal, the interest, and possibly other fees (like an origination fee) by a future date.
The most common form of debt financing is a small business loan from a bank, credit union, or online lender. The definition of debt financing also includes bond issues. Used mostly by larger companies, a traditional bond certificate includes a principal value, a repayment term, and an interest rate. Individuals or companies that purchase the bond then become creditors by loaning money to your business.
How Does Debt Financing Work?
Debt financing can be divided into two categories based on the type of loan you’re seeking: short-term or long-term.
Short-term Debt Financing
Short-term debt financing is usually used for day-to-day operational expenses, such as purchasing inventory or paying employee wages. These loans typically need to be paid off within a year, though some may extend a bit longer. Common types of short-term debt financing include short-term loans from banks or online lenders, business lines of credit, credit cards, and trade credit (accounts payable).
Short-term debt financing tends to be easier to qualify for than longer term financing options, which can make them a good option for newer businesses and companies that lack strong credit. Short-term business loans, however, tend to come with higher interest rates than other types of debt financing.
Long-term Debt Financing
Long-term debt financing is often used for large purchases (or capital investments) like equipment or real estate. You might also opt for long-term debt financing when expanding your business. Generally, the term to pay off these loans is a year or longer.
For large loan amounts, the longer payoff period can make the payments more affordable. These loans also tend to have lower interest rates than short-term financing. However, you generally need to be an established business with strong revenue in order to qualify for long-term debt financing.
Pros and Cons of Debt Financing
Debt financing has both advantages and disadvantages. Here’s a look at how they stack up.
Pros of Debt Financing
One of the biggest benefits of debt financing is that you get to retain full ownership and control of your company. Unlike equity financing, you don’t need to give up an ownership share of your business to obtain the capital. The financial obligation is temporary and your relationship with the lender ends after you pay off the loan.
Another perk is that the payments you make on interest generally qualify as a tax-deductible business expense. This interest tax deduction is typically available as long as you’re borrowing money from an actual lender (not friends or family) and using the loan for business purposes. Other loan costs, such as origination fees, may also be tax-deductible.
In the case of long-term financing, the repayment period can be extended over many years, reducing the monthly expense. Assuming the loan does not have a variable rate, the interest expense is a known quantity for budgeting and business planning purposes.
If you make all of your payments on time, debt financing can help you build business credit. This can help you qualify for other debt financing options in the future, potentially with better rates and terms.
Cons of Debt Financing
You’ll need to make consistent payments on your loan, regardless of your revenue, which could be challenging if you have seasonal business or inconsistent cash flow.
Also, if your business is new or doesn’t have strong credit, interest rates may be high, making this a potentially expensive form of financing. And, if you are late or miss payments, it could negatively impact your credit.
Business lenders often require business collateral or a personal guarantee (or both) to secure loans. If you default on the loan, any business assets you pledge could be repossessed by the lender. If you sign a personal guarantee, you could potentially lose your personal savings or home. These are significant risks to take, so it’s important to understand the terms of your debt financing and feel confident in your ability to repay the borrowed funds.
| Pros | Cons |
|---|---|
| Retain ownership and control over your business | Interest rates can be high if business is not well-established |
| Can help you build business credit | Late or missed payments can hurt credit |
| Interest payments are typically tax deductible | May need to put business and/or personal assets at risk |
| Long-term loans can have low monthly payments | Must keep up payments even during slow periods |
Recommended: What Is the Minimum Credit Score for a Business Loan?
5 Examples of Debt Financing
There are many types of small business loans. Here are some options you may want to consider.
1. Traditional Loans
With a traditional term loan from a bank or credit union, you receive a lump sum of capital up front then repay it (plus interest) in monthly installments over time. Long-term business loans allow you to borrow large amounts for bigger capital projects but tend to come with strict requirements, like a minimum amount of time in business, proof of revenue, and a strong credit history. It can also take several weeks (or more) to get your application approved and receive the proceeds of the loan.
2. Online Loans
Online business loans tend to have more flexible qualification requirements and are typically faster to fund than bank loans. This can make them a good option for companies that can’t qualify for a traditional bank loan or need access to funds quickly. Some online business lenders will work with startups or businesses with bad credit.
Applications are typically vetted almost instantaneously and, if approved, you could get your funds as soon as the same business day. However, these loan products tend to come with higher interest rates than other types of business loans. If you’re considering an online loan, it can be a good idea to shop around and compare interest rates to make sure you’re getting the best possible deal.
Recommended: What Is Seed Funding?
3. SBA Loans
The Small Business Administration (SBA) guarantees these loans, which are offered by banks and other lenders. Since they’re backed by the government (reducing risk to the lender), SBA loans tend to come with low rates, large loan amounts, and long repayment terms. For the SBA 7(a) loan, for example, you can borrow up to $5 million for 10 to 25 years.
SBA loans, however, can be tough to qualify for. Eligibility requirements vary depending on the lender, but generally businesses must meet SBA size standards, be able to repay, and have a sound business purpose. The application process for an SBA loan also tends to be rigorous and can take as long as three months.
4. Short-term Business Loans
Short-term business loan terms typically last for 12 months or less, though in some cases they may extend to as much as 18 months. Common uses for this type of debt financing include working capital, inventory purchases, cash flow, marketing, expansions, improvements, and covering unexpected costs.
Short-term business loans are often offered by online lenders and tend to come with more lenient qualification requirements than long-term, traditional bank loans. They’re also funded quickly (anywhere from one to three business days). These loans may be more accessible for new or small businesses, but tend to come with higher costs.
5. Business Line of Credit
A business line of credit is a type of revolving credit that allows you to borrow money as you need it, up to your credit limit, and only pay interest on what you borrow. In some ways, it works like a credit card. As you use and repay the money you owe, you can access that same credit line again throughout the draw period, which may be 12 to 24 months.
Credit lines can be secured (i.e., require collateral that you own as a guarantee for your loan) or unsecured (no collateral required). Unsecured lines of credit tend to be harder to qualify for and come with higher rates than secured credit lines.
This type of flexible debt financing can be helpful for smoothing out cash flow, covering small expenses, funding projects with undetermined costs, or serving as a backup for emergencies.
Recommended: Conventional Business Loans vs SBA Loans
Choosing Debt Financing for Your Small Business
Deciding on debt financing is a big decision that can impact the future of your business. Here are some reasons why you might consider debt financing as a way to raise capital for your business.
• You’re past the start-up phase. It can be difficult to qualify for loans with attractive rates and terms as a brand new business. In addition, many start-ups lose money before they start turning a profit, which can make committing to a regular repayment schedule risky. Should you default on the loan, you can lose any business or personal assets you used to secure the loan, plus damage your business credit, which could make it harder to get loans with competitive rates in the future.
• You need capital quickly. There are various forms of debt financing that get funds in a business bank account much faster than equity financing or most other alternatives. You’ll want to focus on online options if you’re truly strapped for time.
• You want to maintain full ownership of your business. Lenders don’t want an ownership stake in your business, only the certainty that you can repay that debt. While taking on debt means making a payment with interest each month (compared to no payments with equity financing), it may be worth it if you’re not prepared to give away a percentage of your company and/or do not want to share future profits.
• You anticipate a positive return. While debt financing comes with costs, you may be able to recoup those costs (and more) if the money you borrow leads to an investment that can bring in a significant increase in revenues — a concept known as leverage. For example, if you take out a $150,000 loan with an 8% annual percentage rate (APR) but can get a 15% return on that money, debt financing can be a smart business move.
• You’re comfortable with risk. If you put up collateral or sign a personal guarantee for a business loan, failing to repay the loan could cost you important business or personal assets. Even if you get an unsecured loan, your company’s credit score will be on the line. These are risks you have to be willing to take if you choose debt financing.
Recommended: Unearned Revenue
Alternatives to Debt Financing
The main alternative to debt financing is equity financing, which involves selling a portion of your company’s equity in return for capital. This means the investor will own a certain percentage of the company and have a say in business decisions going forward.
The advantage of equity financing is that there is no obligation to repay the money you acquire through it. Investors also often provide operational expertise and valuable business contacts along with an infusion of capital.
On the downside, you’ll have to share control and profits with the investors. And, the only way to remove investors is to buy them out (which could cost more than the money they originally gave you).
Some sources of equity financing are:
• Crowdfunding
• Venture capital firms
• Corporate investors
• Listing on an exchange with an initial public offering (IPO)
Recommended: What Is Crowdfunding? Definition & Examples
Equity Financing vs Debt Financing
Here’s a closer look at how equity and debt financing compare.
Similarities
Both debt and equity financing allow you to raise capital for your business. You can use those funds for a variety of business expenses, including day-to-day operations, inventory, equipment, real estate, expansion, or hiring staff.
Differences
Debt financing involves borrowing funds from a person or other entity that you must pay back with interest by a certain date, whereas equity financing involves securing capital in exchange for a percentage of ownership in the business.
With debt financing, the lender doesn’t have any say in your business decisions, and your relationship ends once you’ve paid off the loan. With equity financing, on the other hand, investors will often want to have a say in business decisions and the relationship is ongoing.
Another key difference: Investors can often provide valuable industry knowledge and connections, which you would not get from a lender.
These financing options also differ in terms of risk involved. Equity financing tends to be less risky than debt financing because you don’t have a loan to repay or collateral at stake.
| Debt Financing | Equity Financing |
|---|---|
| No dilution of equity | Dilution of equity |
| Maintain full control of business | Share control of business |
| Keep all profits | Share profits |
| Must pay back the money, plus interest | No repayment required |
| No mentorship | May offer mentorship |
| Higher risk | Lower risk |
The Takeaway
Debt financing is when you borrow money to fund your business and pay it back with interest over time. Small business loans are one of the most common types of debt financing.
If you’re thinking about financing your business with debt, you’ll want to consider how much capital you need, your business’s qualifications (including your personal credit score, time in business, and annual revenue), how quickly you need to access funding, and how much debt you can afford.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What are some examples of debt financing?
Examples of debt financing include traditional bank loans, online loans, Small Business Administration (SBA) loans, business lines of credit, credit cards, equipment financing, invoice financing, peer-to-peer loans (crowdlending), and real estate loans.
What are the advantages of debt financing?
One key advantage of debt financing is that it can allow a business to grow more rapidly than might otherwise be possible. Another is that the interest payments on the debt are generally tax-deductible. Also, with debt financing, the company does not have to give up any ownership control in return for the capital, as is the case with equity financing.
Are debt financing and business loans the same thing?
Not exactly. Debt financing is a broad term that means borrowing money for the benefit of your business. Loans are one of the most common types of debt financing. However, debt financing in business also includes selling fixed-income products, such as bonds or bills, to individuals or institutional investors.
Photo credit: iStock/VioletaStoimenova
SoFi's marketplace is owned and operated by SoFi Lending Corp. See SoFi Lending Corp. licensing information below. Advertising Disclosures: SoFi receives compensation in the event you obtain a loan through SoFi’s marketplace. This affects whether a product or service is featured on this site and could affect the order of presentation. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.
Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website .
SOSMB-Q424-035