Last week’s post provided a few options for types of debt you could utilize for your business. This week we wanted to discuss a few more options for you to consider when trying to make the best decision for your business and its future.
Perhaps the most common form of short-term debt is credit cards. Credit cards are a great blessing, but more than other forms of debt can also be a curse if used improperly.
Fortunately and unfortunately, the vulture-like vendors have handed out credit cards like candy. Even in late 2008 and 2009, during our greatest credit crunch over the last 70 years, we are actively solicited every day for a new credit card – in the mail, at the airport, and in the mall. The credit card companies solicit us most everywhere we go.
Credit cards can be a potent tool to establish a credit history for your business. We suggest opening up a business (not personal) credit card with a relatively small credit limit – say $500 to $1,000 and use it on a regular basis. Make sure to watch for overdrafts by not going over your credit limit.
By using the card on a regular basis and paying it off, you are establishing a history of exemplary credit. Your credit limit will increase over time and lenders will line up at your door to give you the other sorts of loans we have discussed.
Additionally, make sure you have a credit card with a rewards program. However, make sure it is one that does not have an annual fee for the program. Many of the elite rewards programs will allow you for only 1,200 points (at a dollar a point) to receive movie tickets or a gift card to your favorite retail store or restaurant.
Make sure the reward program will give a dollar per point. We suggest having a couple of the smaller bills for normal operating expenses like office supplies or traveling to go directly to your credit card. Consider using the rewards to thank your customers and clients for doing business with you without having to spend an extra dime.
Remember, credit cards can be extremely dangerous and expensive. Make no bones about it – the credit card companies are in the business to make money. In the fine print located in the pages and pages of legal disclosures you will receive on a monthly basis, the terms of your contract with the credit card company will change.
If you are not able to pay off a credit card on a monthly basis, we do suggest paying the balance off as soon as you can and close down that account. Otherwise, you are hurting more than you are helping.
Over the last two years, we have seen late payment fees skyrocketing up. Additionally, we have experienced interest rate charges suddenly increasing to 25 percent or 30 percent. The credit card company also reserves the right to review your credit score at any time. Make sure you are not dependent upon the card, because they can cut your credit limit at any time.
Keep in mind that a lot of the terms of the credit card agreement can be up for negotiation. If you have an unfavorable interest rate, you can haggle with the company to lower your rate or lower the fees. Rather than switching from one credit card to another, we find it best in most cases to keep your existing credit card open. If you are closing and opening credit cards, this will cause significant dents into your credit score.
Additionally, a zero percent APR credit card may sound attractive, but they will still have late fees and interest rate charges if you miss a payment. At the end of the day, zero percent is decidedly not zero percent in most cases.
Borrowing from 401(k)s and Life Insurance Contracts
The next crucial way to borrow, which is often the first source people look toward, is to borrow from yourself.
How do you give yourself a loan? Well, if you have money in a 401(k) or a life insurance contract with cash value, you can borrow from yourself.
First, let’s discuss 401(k)s. These are retirement plans offered by an employer – whether past or present. You sock away money in these retirement plans and you can get a tax deduction for doing so. Often, your previous employer or your business will match these funds. With the typical SafeHarbor provisions, the match usually becomes your money when the employer contributes it. Unlike money in a defined benefit pension plan, you have control over where the money can be invested in a defined contribution plan like a 401(k). You also have control over when you want to distribute it and how much. It is truly your money.
One of the features that is not commonly discussed with 401(k) is the loan feature. Most employers have this as an option and if they do not have it, they can get it added for a minimal cost through their third party administrator. One caveat is that you must usually be active in the company to take advantage of this loan feature. So, if you are a business owner and have your own 401k, this applies to you.
Now, once you take a loan, it is a loan that you are borrowing from yourself. Per ERISA guidelines, the loan can only be up to a maximum of 50 percent of the account value on the date of the loan. It must be amortized over a short period and paid back with interest. You can only have one loan at a time from your 401(k). You must pay off the first loan before taking a new one out. The term is usually 5 to 6 years, and the interest rate will be flat. An independent party, usually the third party administrator (TPA) of the plan, determines the interest rate.
What is interesting about this loan is that you are paying yourself interest, not the bank or other entity. Additionally, the interest is tax-free, and there are no tax penalties or early withdrawal penalties when you are taking a loan.
If you are below 59 ½ years of age and you do take a withdrawal from the 401(k) that is a cash distribution, you will get hit with a 10 percent early withdrawal penalty on top of getting taxes on the distribution. You could avoid this tax headache by instead taking a loan.
Below are 2 tables showing a typical loan from a 401(k):
As an alternative to borrowing from the 401(k), you may also want to explore borrowing from a life insurance policy with cash value. Note that the life insurance policy must have cash value. This does not apply to term life insurance policies. They do not have any cash value. Universal life, variable universal life, or whole life policies should have cash value in your accumulation years. Borrowing from your life insurance policies will change from carrier to carrier.
In comparison, 401(k)s are very straightforward and uniform when it comes to borrowing.
Meanwhile, some life insurance carriers will not charge interest after you’ve held the policy 4 to 5 years. This is called a wash loan. With other carriers, your interest rate may be variable. You’ll be credited some interest for owning a fixed policy, but you’ll be charged interest as well. Depending upon interest rate conditions, you may make money or owe money from the difference between what is earned versus what is owed.
No matter the style of the interest, the main thing you need to keep in mind with life insurance policies is that you need to keep them in force. As long as the premiums are being paid and the insurance is kept in force, the loans will be tax-free. However, if the policies lapse because there is no cash left, Uncle Sam could come knocking with a tax bill in hand.
Finally, the last form of leverage is receivables financing which is also known as “factoring.” If your business has a lot of accounts receivable, this may apply to you.
Let’s say there are a lot of clients and customers who owe you money. They haven’t paid in months or even years. Some of them may never pay. You don’t have the time, energy, or resources to get the money from these clients. However, you have a cash need. Maybe you would like to buy a new piece of equipment or to acquire another company and need a down payment.
You may wish to consider financing your receivables. This is not a traditional form of leverage, but is worth considering if you have a cash need or as an alternative to getting debt. Essentially, what you do is hire a company to be your bill collector.
The factoring company will advance you a fee depending upon the receivables and your particular situation – by the time everything is said and done it may range from 50 percent to 90 percent. They will take a fee that is usually less than double digits but will depend on your creditworthiness as well as that of your customers.
This could free up your time to concentrate on what you do best as well as to have some instant cash flow. Unfortunately, the process could be very costly.
We touched on some of ways you can use debt to leverage your business. Now you are aware of some of the pitfalls and consequences of using various kinds of debt. Consult with your mentorship team/board of directors to determine what structure may be best for you.
Feel free to contact us at dave@daviddenniston for a second opinion and an overall evaluation of your situation.
Material discussed is meant to provide general information and it is not to be construed as specific investment, tax, or legal advice. Individual needs vary & require consideration of your unique objectives & financial situation. Please consult with your accountant or tax advisor for specific guidance.