By Steve Nicastro
Don’t become a small-business statistic.
Nearly half of small businesses don’t make it past the first five years, according to the U.S. Small Business Administration. Optimistic owners may underestimate the costs of starting a business, run up too much debt or have bad personal credit that keeps them from getting a business loan. Then it’s curtains.
In honor of the new year, here are five stupid small-business mistakes to avoid in 2016, so you’ll still be around in 2021.
1. Not repaying expensive variable-rate debt
The Federal Reserve’s first interest rate hike in nearly a decade means small-business owners will pay more on existing variable-rate debt, such as business credit cards and adjustable-rate mortgages, in 2016.
Business owners should only borrow money if they are confident they’ll earn a higher rate of return than what the debt costs. And that’s pretty tough to do with credit cards, which typically carry an annual percentage rate in the mid- to high teens. APR is the true annual cost of borrowing, including all interest and fees.
Think about it: If you carried a credit card balance of $10,000 at 17.75% APR, it just went up to 18% with the Fed’s rate hike of 0.25%. You’ll have to earn an annual return greater than 18% to earn a profit. The debt is costing you $1,800 in interest annually, and if you make a minimum monthly payment of $200 each month, it will take you seven years and seven months to repay the debt in full (and you will have paid more than $8,000 in interest). Ouch.
Repaying a $10,000 balance at 18% APR earns you a guaranteed 18% annual return on your cash — where else can you earn 18% guaranteed?
The same thinking applies to adjustable-rate mortgages: If you’re paying a high APR, it may be time to repay the remaining debt (if you can) or refinance into a fixed-rate mortgage at a lower rate, but only if your expected savings outweigh the costs of refinancing.
2. Neglecting your personal credit
In a lender’s eyes, poor personal credit indicates you don’t handle your finances well, so you likely won’t handle your business finances well, either. Improving your personal credit score can increase your chances of landing small-business financing.
It starts with making all payments — credit cards, student loans, car loan and mortgage payments — on time; payment history makes up 35% of your credit score. It’s also wise to keep your total debt low in relation to your credit limits, as credit utilization comprises 30% of your score. In general, you should keep your credit utilization below 30%. For example, if you have $10,000 available credit on all accounts, keep your debt at $3,000 or below.
But your personal credit score may also be suffering due to errors on your credit report. Federal research has shown 25% of consumers have errors on their credit reports that might be affecting their credit scores. You can get your credit reports for free once per year at each of the three major credit reporting bureaus — Experian, Equifax and TransUnion — at AnnualCreditReport.com. If you find any errors, you can dispute them online through all three credit bureaus’ websites. This may take some time and effort, but getting errors removed should improve your score.
3. Not opening up a line of credit in advance
As a small-business owner, emergencies happen. Your roof is leaking. The plumbing is busted. A piece of equipment breaks. That’s why having access to extra funds is critical.
But waiting until the moment you need cash is not smart. What if you can’t wait several days for funding? Or what if you’re denied financing? Take out a revolving line of credit in advance.
A business line of credit gives you access to cash that you can borrow as needed. You can continue to borrow and repay from the credit line, as long as you don’t exceed the credit limit, and you only pay interest on what’s borrowed. This makes it useful for emergencies or managing cash flow.
It also makes sense for seasonal businesses that experience financial peaks and valleys throughout the year. You can draw from the line of credit during slow months and repay it in full when business picks up.
For businesses with unpaid invoices, another short-term financing option is invoice factoring, where you sell your invoices to a third party for upfront cash, minus a fee; or invoice financing, where you use your unpaid invoices as collateral to obtain a cash advance or a line of credit.
4. Mixing personal and business finances
Like oil and water, your personal and business finances do not mix. Muddling them together is one of the biggest financial mistakes you can make as a small-business owner, for a few reasons:
- It makes it more difficult to track your profits and losses for the business, and budgeting and tracking business expenses can become a nightmare.
- Lenders will want to know how your business is doing and may require separate income and bank statements. The lender also may not take your business as seriously if you commingle finances; they may think it’s just a hobby.
- It can be harder to identify legitimate business expenses and separate them from personal expenses, which makes taking the proper business deductions at tax time difficult.
- The IRS may audit your business if there’s no clear separation between your business and personal expenses.
To avoid this mistake, never use business credit cards for personal reasons, and keep a separate business bank account for all your business transactions. You should also establish a legal entity for the business (an LLC, or an S or C corporation, for example) and obtain a federal business tax ID, if you haven’t done so already.
5. Failing to shop around for financing
A Lending Tree survey found that 58% of small-business owners did not shop around when searching for small-business loans online. You’d shop around for a mortgage or a car loan to get the best rates and terms, so why not shop around for a small-business loan? It doesn’t hurt to see what your options are.
Besides APR, factors to consider when comparing small-business loans include:
- Are there extra fees or charges added to the loan, such as prepayment penalties, application fees, and loan processing or underwriting fees?
- Is the interest rate fixed or variable? If it’s variable, it can change based on an underlying benchmark index that fluctuates with the market.
- Does the lender report payment activity to the credit bureaus? If so, that could help you establish good credit for your business.
- Do you meet the lender’s minimum requirements? Some lenders require aminimum personal credit score, annual revenue and time in business; others place more value on your cash flow.
- Do you need collateral? That’s an asset, such as real estate or equipment pledged as security for repayment of the loan. Find out all of the requirements before applying to save yourself time and stress.
- (Note: You likely want to avoid a merchant cash advance; with APRs typically in the triple digits, this is one of the most expensive forms of financing you’ll find and is only for those with no other options.)It’s also smart to search for the right type of loan based on your business’s needs. For example, if you are looking for a large loan for a real estate purchase or a business acquisition and you can wait a few months, you’re likely better off comparing bank loans than looking online. If you don’t qualify for a bank loan or if you need money fast (within a few weeks or less), online lenders could be right for your business.Steve Nicastro is a staff writer at NerdWallet, a personal finance website. Email: Steven.N@nerdwallet.com. Twitter: @StevenNicastro.
VLM Stone 1/7/2015