Business Debt Consolidation: How It Works and When It Helps

When a business takes on a new loan to pay off a number of existing ones, that’s debt consolidation, which is useful when you need lower payments and can qualify for a more favorable rate. It gives you just one payment each month, making accounting simpler and more efficient. The payment can be lower than the total of those many monthly bills, freeing up cash for the business to spend on bills, marketing, and growth. Also, the new rate can be a few percentage points lower than you’re paying now, saving more money. But it isn’t always helpful, or wise: avoid it when you can’t qualify; when fees or penalties eat the savings; or when shortening the new term just raises your payments.

To consolidate, you find a lender and apply for the new loan. For this step, you’ll need to know exactly what you owe now (to make sure the new loan will cover all the debt), your company history, some financials, and other details. Lenders consolidate debt by paying off your old, existing loans with your new one, then collecting just one payment from you going forward, leaving just one debt to track on a balance sheet, invoice schedule, or accounting software.

The Blended Rate of the Current Loans

The question is what that new rate will be: you want it to be lower than what you pay now. But one rate is not really being paid: when a business carries several loans, the rates are all over the board, and the key number is the combined, average cost. The thought exercise here is to check if the blended rate of the current loans is higher than that of the new loan. Example: debt consolidation for $200,000 over 36 months. Current debts are at a blended 19% interest. New term loan is at 12%. Over 36 months, the new loan would save about $22,000 in interest.

As a rule of thumb, combining a few short-term loans into a longer term gives lower payments but you’ll be paying interest for a longer time, so total interest can add up more. If you’re more concerned about cash flow today, the lower payment can be well worth it. The math needs to be done ahead of time to see if it’s worth doing.

The savings from consolidating a series of cash advances or daily-debit loans can be huge if you can qualify for a 12-18% interest loan and switch to one payment per month. Blended cost on these can reach 30% to 80%, or more. Changing from weekly or daily to monthly payments frees up cash that’s now being drawn from your checking account: just what you need in month when other expenses are higher, or business is slower than usual, but the daily or weekly loan payment is still going out, even if you lack sales that week or month.

More benefits to consolidation: it gives you a better chance of success if your credit has improved since you applied for the first business loan and can now qualify at a lower rate. It can also lower your bills enough to pay other, more urgent or frequent bills such as payroll, utilities, supplies, inventory, repairs, advertising, rent, so you no longer have to rob Peter to pay Paul or take on additional loans. Be on guard, though, if the new debt service eats too much of your working capital.

Be on the lookout for a few situations:

• First, if there are prepayment penalties on the old loans, they can cost more than the interest you’d save, eating up the benefit.
• Second, if the new interest rate isn’t at least 3-5 percentage points better than your current blended average, the origination fees may wipe out the benefit.

Third, hold off if one of the loans or credit card debts is nearly paid off: rolling just six months left into a new three-year loan resets the clock and will probably cost more interest overall. And if the savings from consolidated debt means you’ll use the freed-up cash to take on additional debt, you could be falling for the lure of using new debt to pay old debt, rather than living within your means.

Qualify for Better Rates

It’s not always easy to qualify for better rates when you most need them: it takes good credit or strong cash flow. Past defaults will come back to haunt you; the lender will review your current credit report. Lenders gauge a business’ ability to handle the new debt through a ratio called debt service coverage (DSCR). Most conventional lenders want at least 1.25, meaning $1.25 of income available per every $1 of monthly debt. This shows the likelihood that you can make monthly payments and that the lender will get paid. And consolidating debt to reduce your payments can make your DSCR look better. Tip: aim for a credit score above 650 for most term loans, or above 680 for an SBA loan.

Financing from the Small Business Administration (SBA) can be another option. An SBA 7(a) loan up to $5 million is the general-purpose category that can help with a refinance. This loan can refinance some business debt but the repayment number generally has to be at least 10% less than the current one. And your existing debt has to be on schedule for the past year. The SBA disallows refinancing active MCAs. It requires them first to be converted into a term loan. And if you can only qualify for a loan in the higher-rate category of business debt consolidation, that may defeat your goal.

Keep in mind that debt consolidation and debt restructuring are separate processes, though both seek to improve cash flow. Restructuring gets worked out through negotiation between debtor and lender, ideally before the debt is in default, whereas consolidation replaces the old loan(s).

Cost vs. Benefits

Before you apply, work out your blended, average rate of all loans. To find if the new loan will be less expensive, first list all the loans to be consolidated. For each, list the balance, interest rate, payment amount, any prepayment penalty, term left, and when you got it (hint: that was when the clock started running). Then get at least three to five quotes for a new loan; compare the results. This can be a lot of work for a busy owner, but it’s got to be done. When doing a cost vs. benefits check, factor in the origination fees, prepayment penalties, and change in DSCR by lowering the outgoing payments.

Strong hint: after you take on the new loan, follow up with a simple phone call or email request for payoff letter from each of the old lenders. Best to stay on top of them and make a clean break.