Borrowing can be harmful, but the key to success is understanding how to use debt wisely.
Borrowing beyond means can be harmful, especially high-interest debt, but there are instances when debt may be helpful. The key is to understand and respect the difference, know your debt-to-income threshold – amount of debt versus liquid assets – and use debt wisely. It’s true for your personal life, as well as your professional one.
Constructive vs. Destructive Debt
It may seem counterintuitive, but “good” debt, like business financing, can actually enhance your financial position. Additionally, this type of loan often offers a low total cost of borrowing. Destructive debt has the opposite effect, eating away at your credit rating and putting you or your business in a vulnerable financial position. Bad debt is usually associated with buying things you simply don’t need or can’t afford.
Being overleveraged can derail a business from increasing net worth. That’s why it helps to understand debt-to-income ratio, the percentage of monthly gross income that goes toward paying obligations. Generally speaking, 36% or less is considered a healthy debt load for most.
Prepared for Anything
Having ready access to liquidity through a loan also puts you in a position to act quickly should opportunity – or an emergency – arise. In the first case, cash can be invested, potentially earning a much higher return, and you’ll have liquidity for other goals. Perhaps you find a perfect new location or want to invest in equipment. Instead of liquidating assets, tap into a loan and make an all-cash bid for a property.
Build Credit with Credit
Borrowing, making payments on time and paying off a business loan helps establish an excellent credit rating – and can keep you from entangling your own finances by personally guaranteeing business loans. It can also result in lower future interest rates and fees for borrowing.
A Smart, Powerful Tool
Borrowing in a smart and efficient way has a place in just about any business plan. The key is to consider each facet of debt strategically. As you make your decisions, think about:
- How much debt you’re willing to take on
- Whether you prefer to sell assets or borrow
- The anticipated cost of borrowing
- Borrowing in the name of your business, not your own name
- What loan structure makes the most sense: traditional, adjustable-rate or collateral-based, among others
- The tax ramifications of a loan compared to cash on hand
- How quickly you need the money
- How long you’ll need the loan
- How you’ll pay off a loan and when
Debt can be a powerful tool that enables you to use capital in other ways, thus helping you achieve your goals faster than saving might. Remember, too, that taking on some debt is a financial decision, one made easier with a little help from knowledgeable professionals – like your financial advisor.
Next Steps:
- Get a good handle on your debt-to-income ratio.
- Ask yourself if low-interest debt can help you thoughtfully grow your business or build credit.
- Talk to your advisor to see if smart borrowing fits into your business’s balance sheet.
