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Advantages and Disadvantages of Debt Financing

accountant37004036.jpgMany new business owners choose debt financing, if they decide that they do not want to take on investors, and want total control of the business. Debt financing is most commonly used in order to start up a new business.

Most potential business owners try to tap their own sources of funds first, by using personal loans, home equity loans, and even credit cards. In addition, family or friends are sometimes willing to loan the necessary funds at lower interest rates, and better repayment terms. Finally, business owners turn to the next level of debt financing by applying for a business loan. However, before you choose debt financing, it is important to understand both the advantages and disadvantages of this business finance method. The advantages of debt financing are as follows-

  • This method of financing allows you to have the ultimate control of your own destiny, in regards to your business. You will not have investors or partners, that you have to answer to, and you can make all the decisions. You will also own all the profit you make.

  • The interest you repay on your loan is tax-deductible, if you finance your business using debt.This means that it shields part of your business income, from taxes and lowers your tax liability every year. In addition, there are many tax benefits available to small businesses. Keep in mind that you can apply for a Small Business Administration loan that has more favorable terms for small businesses than traditional commercial bank loans.

  • The lender(s) from whom you borrow money do not share in your profits. All they expect from you is to make your loan payments in a timely manner.

  • There are also significant disadvantages to using debt financing-

  • The disadvantages of borrowing money for a small business can be great. One of the major reasons is that you may have large loan payments, at precisely the time you need funds, for start-up costs. In addition, if you don't make loan payments on time, to credit cards or commercial banks, you can ruin your credit rating, and make borrowing in the future difficult or impossible. And most seriously if you don't make your loan payments on time, to family and friends, you can strain those relationships.

  • Because you are part of a new business, commercial banks may require you to pledge your personal assets, before they will give you a loan. You must remember that if your business goes under, you will lose your personal assets. Coupled with this is that fact that any time you use debt financing, you are running the risk of bankruptcy. The more debt financing you use, the higher the risk of bankruptcy. Many people find themselves in over their heads, rather quickly when using debt financing to start their business.

  • You could be open to serious liability. While many people believe that if you incorporate your business, your personal assets are safe, this may not be true. Even if you incorporate, most financial institutions will still require a new business, to pledge business or personal assets as collateral, for your business loans. Failing to repay means that you can still lose your personal assets.

Even after examining different types of business financing, many people are still left wondering which method is best for them. The answer is-it depends on the situation. Your financial capital, potential investors, credit standing, business plan, tax situation, the tax situation of your investors, and the type of business you plan to start will all have an impact on that decision. Carefully reviewing your business plan and consulting with professionals can help you make the best decision for yourself and your business.

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