Why You Should Be Wary of Business Payday Loans
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Business payday loans are short-term funding options available to businesses who need money quickly. Also known as a merchant cash advance or business cash advance, a payday loan for businesses is one of the most expensive forms of financing and is not federally regulated. Generally, you’ll want to consider all other types of small-business loan options — and weigh the pros and cons of this alternative lending product — before you commit to a business payday loan.
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What is a business payday loan?
A business payday loan is not technically a loan at all, but rather a cash advance based on future earnings. While you do receive cash upfront with this financing option, the process of repaying the funds is different from that of traditional loans. There is often no set payment amount. Instead, payments of a business payday loan are taken, often automatically, as a percentage of your daily or weekly credit and debit card sales until the debt is paid off.
There are few, if any, restrictions on how a payday business loan can be used and qualifying can be easier than for other types of business loans. You typically don’t need good credit and aren’t likely to be asked for collateral. However, this flexibility is often traded for higher interest rates and fees.
How does a business payday loan work?
A cash advance company provides a business with a lump sum of cash that is repaid through a percentage of the business’s debit and credit card sales.
Although the process varies, the amount advanced is generally based on a business’s bank statements and other sales records. Once approved, the business receives the funds quickly, within 24 hours in some cases.
Depending on your agreement with the cash advance company, daily or weekly payments are deducted from your debit and credit sales or from your business bank account.
Cash advance companies charge a factor rate instead of a loan interest rate. Factor rates vary, but a range of between 1.1 and 1.5 is common. Also, factor rates represent the total amount you will pay back — the advance amount plus the fee.
For example, with a cash advance of $10,000 and a factor rate of 1.1, you’d pay back $11,000 — the original advance of $10,000 plus a $1,000 fee. With a cash advance of $10,000 and a factor rate of 1.5, you’d pay back $15,000 — the original advance of $10,000 plus a $5,000 fee.
» MORE: Cash advance APR calculator
What is a confession of judgment?
A traditional business loan may require you to offer collateral or a personal guarantee to ensure repayment of the funds. In contrast, businesses seeking cash advances are often required to sign an agreement that includes a confession of judgment (COJ).
If you agree to a COJ and then default on the payday loan, the cash advance company can obtain a judgment against you without any advance notice, in some cases. Clauses within the COJ may not allow you to defend yourself before the judgment is filed or may limit you in your choice of an attorney.
Because COJs don’t benefit borrowers and can damage their finances, it’s important to get legal advice before signing any contract that includes this clause.
Pros and cons of business payday loans
Fast funding: Funding can be as fast as 24 hours. The approval process may be expedited if you grant the cash advance company access to your bank transaction data.
Flexible qualification requirements: You often don’t need strong credit to qualify. Instead, companies will focus on revenue and want to see your card receipts and business bank account statements.
Payments adjust with sales: Your repayment amount is based on a percentage of your sales. Lower sales mean a lower repayment and higher sales mean a higher repayment amount.
Expensive: Business payday loans are one of the most expensive forms of business financing with estimated APRs ranging from 40% to 350%.
Frequent repayments: A business payday loan can require daily or weekly payments of the advanced amount.
Short terms: The repayment term often ranges from three to 18 months.
Not federally regulated: Business payday loans aren’t technically “loans” and are not subject to federal regulations. Some lenders may not follow the rules that traditional lenders must adhere to.
Alternatives to business payday loans
Because business payday loans are often expensive and could potentially put you into a debt cycle, you may want to consider other financing options.
Business loans. A bank business loan will generally offer you the best interest rates and terms. If you have difficulty qualifying, you may improve your chances for an approval by providing a cosigner or collateral — a business asset to secure the loan. Online business loans can be easier to qualify for than bank loans and typically have faster funding times, but also less competitive interest rates.
Business credit cards. A business credit card may be another option to consider if funds are needed fast. You’ll typically make monthly payments with a business credit card, instead of the daily or weekly payments required for a business payday loan. Interest rates and annual fees vary based on the lender and your qualifications.
Family and friends business loans. If you find you need funds quickly and are having difficulty getting approved for a traditional business loan, you may want to consider a family and friends business loan. Personal loans from family and friends don’t require a formal application process, but it is important to put the terms of the agreement in writing to avoid any misunderstandings down the road.
Invoice factoring. While business payday loans are based on future sales, invoice factoring offers funding based on the cash you are owed from previous sales. Because the factoring company buys your invoices for cash, you can avoid taking on any additional debt. Factoring companies don’t advance the full amount of the invoices they purchase, but instead keep a portion as a fee.
» MORE: Best invoice factoring companies
