The Dangers of Cash Advance and Short-Term Loans
5 Essential Questions to Ask When Considering Cash Advance and Shorter-Term Loan Options
What is a cash advance loan?
Cash advance loans, also known as merchant cash advances (MCAs), are the product that birthed the online lending industry.
A solution for business owners ineligible for bank approval, cash advance provides business owners with quick cash. In exchange, business owners pay back the amount (along with fees) from a set percentage of their daily credit card sales.
Are cash advance loans really loans?
Cash advance companies do not actually offer loans—rather a sale of some portion of future credit or debit card sales. Therefore, cash advance companies claim they are not bound by state usury laws. Usury laws are what limit lenders from charting high-interest rates, typically 40 to 90 percent. This technicality allows them to operate in a largely unregulated market, and charge much higher interest rates than banks.
History of cash advance loans
Cash advance loans were originally structured as lump-sum payments to a business in exchange for an agreed-upon percentage of future credit and debit card sales. For businesses used to being told “no” when they needed financing, MCAs were revolutionary.
Rising resistance from businesses
However, it wasn’t long before lenders saw hesitancy from businesses to change their payment processors (oftentimes required). Not to mention, the direct pull from daily sales was discouraging to hard-working entrepreneurs. They’d work for hours to make sales, only to have a significant portion gobbled up every day.
Birth of the short-term loan
With time, this led to the development of the short-term loan product. These are loans with 3- to 18-month terms, repaid daily through ACH debits out of a business bank account. While payments still hit the business owner every business day, not having to change payment processors and pulling a percentage of daily sales made them easier to sell. As the two products have continued to differentiate themselves, the short-term loans have become less expensive than cash advance loans, but not by much.
Together, cash advance and short-term loans make up a good portion, if not the majority, of online loans. But they can be very dangerous products if not approached wisely and used properly.
Here are five questions to consider when it comes to cash advance and shorter-term loan products:
Is it right for my business model?
With cash advance loans, you’re paying back a set percent of your daily sales. So while you do pay back more when business is better and less when business slows, if you don’t receive a ton of daily transactions, it will take forever to pay the advance off.
Similarly, with short-term loans, you’re getting debited every business day. If you don’t have money coming into your bank account frequently, there’s a chance these withdrawals could leave your bank account at $0, if not negative.
Cash advance and short-term products tend to work better for businesses that have daily transactions, such as restaurants or salons. If you only receive a few big payments a month from customers, you should have a conversation with your accountant, financial advisor, or lender to see if this product will actually work for you. Or better yet, avoid it altogether. It might be all you’re qualified for, but you don’t want to find yourself paying hefty overdraft fees regularly and putting your business in a compromising position.
Is it all you qualify for?
Another obstacle facing business owners during their financing search is loan brokers. While some loan brokers are looking out for your best interests, far too many are not. Loan brokers are notorious for calling business owners daily, telling them they can get them financing—fast! You probably ignore them now, but what happens when you need quick cash to get a project off the ground? It’s all too tempting to say “let’s do it” to the person on the other end of the line.
More times than not, these brokers are pushing cash advance and shorter-term products. After all, this is where brokers make their most money. But that doesn’t necessarily mean it’s the only product you qualify for.
We have businesses come to us to refinance shorter-term debt when they could have qualified for a longer-term, less expensive loan in the first place. Not taking the time to shop your options could cost you thousands.
What are you using the money for?
Cash advance loans are extremely expensive. And while shorter-term loans can be more affordable, they can also be shockingly pricey. That’s why you need to think twice before taking on this type of debt.
If you are looking for financing for a revenue-generating opportunity, this makes a lot more sense, assuming you’ll be making more off the opportunity than the cost of the financing. But if you’re looking because you’re in a cash crunch, tread carefully. Some of the worst decisions are born out of desperation. While this may be all you can qualify for, do you have a clear plan for how you’ll pay it back? It might be best to explore other ways to get your business back on better financial footing.
Are there any alternatives to these online lenders?
In many cases there are. Your bank is a great place to start. There are innovative programs out there offered by banks that serve as alternatives to traditional loans, while at the same time providing you with much-needed funding. Everyone always talks about how banks aren’t lending and the online lenders are the only way to go; however, banks have and are adapting to fill the gaps.
One option is accounts receivable purchase. This is where you sell your invoices to the bank and receive the majority of the invoice amount in advance while waiting for your customer to pay the invoice, which usually takes 30, 60, 90 or more days. This is a more structured and cost-effective way to obtain the working capital you need. Once the invoice has been repaid by the customer, the bank deducts a small fee and remits the balance to you. There are no long-term contracts, no daily debits on your bank account, and no hidden fees. Accounts receivable purchase even provides free customer credit checks, to help ensure your invoices get paid.
Does entering into a merchant cash advance loan or online short-term loan violate or jeopardize your existing relationship with your bank?
The answer in many cases is YES. If you have a credit facility with your bank, odds are they have a UCC-1 (lien) on all or most of your assets. With daily debits under the merchant cash advance loans, which infringes on the bank’s UCC-1 by taking cash from accounts receivable, therefore, putting you in default under your credit facility with the bank.
If you’re considering cash advance loans—or even a shorter-term loan—keep these things in mind. Always talk with your banker and explore all available options before signing. Remember: You should always leave your bank meetings with a greater understanding of your finances and clear a direction for your future.