How to Decide Between a Short-Term and Long-Term Business Loan
Before deciding between a short and long-term business loan, you’ll need to answer questions about your current and projected financial health, as well as your tolerance for risk. However, before you answer those questions, you’ll need to understand the difference between short and long-term loans, so we’ll start there.
The Difference Between Short and Long-term Business Loans
It’s easiest to understand the differences between these loans when you look at them from a lender’s perspective.
On any loan, the lender wants to make a return large enough to compensate them for their risk. The lender’s return will come in the form of fees and payments. The risk lenders take is called default risk, which is the risk of the borrower being unable to make their payments.
With all else equal, a long-term loan is riskier than a short-term loan for the lender. Why? Put simply, because as time goes by, more bad things can happen. Maybe you run into some bad luck, or the economy falters. Whatever the case, the longer the lender has their money tied up in you, the riskier it is for them. Lenders are compensated for this risk because a longer term means you’re paying back the loan slowly, allowing more time for interest to accumulate.
Also, at the risk of stating the obvious, long-term loans have a longer term than short-term loans. A short-term loan, according to The Financial Dictionary, lasts for one year or less.
Now that you understand the difference, how do you decide between the two?
Evaluating Your Business Needs and Preferences
Understanding Cash Flow Needs
Timing is an important factor when you’re deciding on the term of your loan. At the very least, you must have cash available to pay your loan when it comes due. However, even if you have enough cash when the loan is due, an ill-timed loan due date could still put a serious financial strain on your business.
For example, let’s say your loan payment is due and you pay it back, but now you have very little cash left. Chances are, you’ll be left scrambling to pay other bills or forced to delay other investments. To avoid this, make realistic projections about your cash flow. As you do that, make sure to consider what other expenses you may have that will affect cash flow as you approach your loan payment date.
Deciding on Your Risk Tolerance
Every entrepreneur must take a risk to succeed, but the size of the risk that each entrepreneur is willing to take varies. It’s important to note that there’s really no “correct” answer to how much risk you should take. Moreover, when you’re deciding between a short-term and long-term loan, the respective risks of these two types of loans depend on context.
Sure, with all other factors equal, a long-term loan is riskier. However, in the real world, all other factors are rarely equal. Generally, you’ll have to make larger payments on a short-term loan because you have to pay it back faster than a long-term loan. Looking at it from this perspective, you could say a short-term loan is riskier for you if the larger payments are likely to cause you financial hardship.
Current and Future Financial Health
Every business owner across the United States wakes up each morning facing a unique set of opportunities and threats, both long and short-term. If you’re facing a wide range of opportunities that you don’t have the cash to investigate, perhaps a short-term loan makes sense so that you can do the research needed to see which opportunity is worth going all in on.
However, if you’re just getting started, and short-term cash flow is uncertain, you need to give yourself more time. In that case, a long-term loan may make more sense.
The Small Business Default Indices (SBDI) tells us the percentage of small business loans that have defaulted. As of today, the SBDI sit at less than 2 percent, according to PayNet. That, per the Small Business Administration, is near an all-time low.
Suffice it to say, the chances of you defaulting on a business loan, short or long-term, are low. Still, you should do a thorough analysis of the factors we’ve discussed and take great care when deciding between a short and long-term business loan.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.