Despite the common stigma, debt isn’t always a bad thing. According to the American Psychological Association, 64% of Americans cite money as a significant source of stress. Most people believe that no debt is good debt, but depending on financing, that’s not always true. For the majority of individuals and businesses, most big purchases, such as a new home, car, business equipment, and materials, etc., can only be afforded through loans. This kind of debt isn’t necessarily bad as long as you can manage the payments on time and could even potentially boost your credit score or good standing with future business lenders.
What is good debt?
Many types of debt are categorized as good. Good debt will help you leverage your finances and be used to invest in essential things, such as real estate, education, and business. Good debt also essentially generates income and increases your net worth. Additionally, debt that you’re able to pay back responsibly can help you create a reliable and favorable payment history on your credit report, thus improving your credit score as well. With a reputable payment history and a good credit score, you’ll likely continue getting approved for more financing that can grow your good debt. For example, if you get approved for a home loan, make consecutive payments on it, and later decide to open a business. Loan officers will be more likely to approve another new loan to help start your business because of the positive payment reputation you’ve built with your home loan.
Examples of good debt in business
If things like home loans or student loans are great examples of good debt when it comes to your personal finances, then what’s considered good debt when it comes to business? Since the pandemic, the construction business has been booming, leading to an abundance of work but not enough cash in hand to start new projects. There’s a lot of variation for good debt in the construction industry. Examples of good debt in a construction business include:
- Materials Financing – Materials financing is a type of financing designed specifically for contractors for construction materials. A material financing provider fronts the costs for your construction material needs so that you can have the supplies to advance on larger projects. The contractor can then pay back the materials costs over time, depending on the loan term, and confidently manage cash flow while growing their business.
- Invoice Factoring – Contractors can sell their unpaid invoices to a lender for a cash advance. With commercial invoice factoring, you can immediately free up cash from outstanding invoices, helping you to continue bidding on new projects while better managing invoice debt. If the customer doesn’t pay back the invoice in time, there are two types of invoice factoring options: recourse and non-recourse. With recourse factoring, the contractor is responsible for buying the invoice back; instead, with non-recourse, the lender will assume all risks.
- Lending – Obtaining a business loan can help business owners manage and balance their cash flow while taking on new projects without delay. Monthly payments such as employee wages, inventory supplies, office lease bills, general operations, etc. can pile up and be quite daunting when considering taking on a new costly project. Properly utilizing business loans to maintain your cash flow and regular expenses will allow you the freedom to start new projects without hesitation, further growing your business.
- Line of Credit (Seasonal Credit) – Additional lending options, such as a line of credit, can also help offset costs during slower seasons. Some business owners face a “shoulder season” where certain times of the year tend to lag for one reason or another. Seasonal credit is a flexible option, allowing business owners to consistently pay and manage expenses despite any drastic revenue changes from month to month.
Additionally, payday loans also typically come with hefty added fees and are restricted depending on your state’s laws.
Good debt vs bad (high interest) debt
Generally speaking, borrowing money for something that immediately depreciates in value, such as cars, is considered bad debt. When it comes to business, there are types of debt with higher interest than others. Payday loans, for example, are infamous for being high interest and are a short-term option with the notion that you’ll pay back the loan in full when you receive your next paycheck. Additionally, payday loans also typically come with hefty added fees and are restricted depending on your state’s laws, leaving them to be considered a bad form of debt. Good debt won’t have a high-interest rate, and the lender will work with you to offer an interest rate that’s fair to your finances. Higher interest rate debt makes it increasingly difficult to pay it back, sometimes resulting in missed debt payments that could negatively impact your credit score, making it more difficult to get loans and other finance options in the future.
How to leverage good debt to build a business
Timing is often crucial for both small and large businesses, and it’s essential to have the financial stability necessary to support business growth. When businesses leverage their debt to generate additional income, it can expedite current projects, goals, or expansions that otherwise would’ve taken longer to obtain. Here are a few ways to leverage good debt to build your business:
- Establish good business credit – Like individuals, businesses also get credit scores. Taking on debt will help a business build its credit and to increase its credit limit with lenders.
- Create continuous cash flow predictability – Business loans help business owners better manage their cash flow and leverage existing profits.
- Expand your company – Business owners can expand by hiring more employees or get a bigger office space by getting a loan instead of waiting for cash.
Everyone’s financial situation differs; when taking on debt, it’s always important to weigh your pros and cons to decide whether or not it’s beneficial to your company. The amount of money and fund allocation plans are often the first two things to consider. Additionally, interest rates, fees, and the payment timeline play a vital role in whether it will be good or bad debt for your company. Business owners should also thoroughly understand their Return On Investment (ROI) of the planned loan allocation to determine if it will support business growth and earning potential.