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How to Use Excess Cash to Pay Down Business Debt

By Spodek Law Group | February 20, 2024

How to Use Excess Cash to Pay Down Business Debt

Prioritize High-Interest Debt

The first step is to target any high-interest debt, which refers to debt with an interest rate over about 6-8%. This includes credit cards, short-term loans, and variable rate loans. Paying these debts down faster stops excess interest charges from accruing and provides the best “bang for your buck.”

For example, if you have $10,000 available, focus first on credit card balances over 15-25% APR before paying extra on a business term loan with 6% APR. There are Reddit threads and Quora posts that provide more detail on this concept.

Pay Down Variable Rate Debt

Variable rate debt refers to loans with interest rates that fluctuate over time, often based on indexes like the prime rate. Since variable rate debt carries future interest rate risk, paying these balances down with excess funds can be smart. This is especially true if rates are projected to rise steadily in the coming years.

For example, NerdWallet suggests using extra profits to pay down variable business loans when possible before interest rates potentially spike. Reducing variable rate debt provides more certainty on future interest expenses.

Consolidate Debt When Beneficial

Another option is to consolidate multiple high-interest debts into one loan with a lower fixed interest rate. This allows you to streamline monthly payments into one lower payment. Online sites like LendingTree and Fundera allow you to easily compare business loan and line of credit offers.

Just be sure to factor origination fees and early repayment penalties into the decision. Avvo and LawInfo provide more guidance on when consolidating business debt is recommended.

Pay Down Term Loans Methodically

For medium to long-term business loans that have fixed interest rates below 8%, focus on paying down the principal every month before turning attention to lower cost debts. Set up automatic monthly payments to make sure you chip away at these term loans consistently.

Term loans also tend to have prepayment penalties, so consult with your lender before making lump sum payments. Legal sites like FindLaw outline the rules around prepaying term business loans.

Build Up Cash Reserves

It’s also important to balance debt repayment with building a cash reserve fund equal to 2-6 months of fixed operating expenses. This rainy day fund provides a buffer in case of an emergency or revenue slowdown.

As noted on Reddit, views are mixed on ideal cash reserve levels for small businesses. Holding some cash likely makes sense rather than putting every excess dollar toward debt.

Other Tips & Considerations

  • Use excess operating profits first – Prioritize paying down debt with true operating profits rather than one-time cash windfalls. This ensures debt payments are sustainable.
  • Review loan covenants – Loan agreements often include covenants or triggers related to cash balances and financial ratios. Understand restrictions before directing excess funds toward debt.
  • Assess prepayment penalties – Many term loans ban prepayment for a set period and/or charge 1-3% fees for lump sum payments. Check with the lender first.
  • Evaluate relative urgency – Consider the urgency to reduce debts owed to critical vendors or business partners versus more patient capital sources.
  • Weigh strategic goals – If major growth initiatives are planned that require capital, it can make sense to conserve more cash and pace debt payments.
  • Consult with advisors – Discuss the best use of extra funds with your accountant, financial advisor, banker, and legal counsel to determine what’s optimal.

The Benefits of Paying Down Debt

Paying down business debt faster by deploying excess cash has many benefits:

  • Less interest paid over time – Each extra debt payment reduces the principal balance that interest accrues on.
  • Cash flow improves – As debts are paid off, more cash is freed up every month for other business needs.
  • Taxes may decrease – Less interest paid means lower tax deductions, but improved cash flow often offsets this.
  • Credit score rises – Demonstrating fiscal restraint can improve your personal and business credit standing over time.
  • Loan options expand – With lower debt levels and better credit, more financing options open up at better rates.
  • Cushion for emergencies – There is less risk of missing payments if an emergency arises.
  • Flexibility for pivots – Financial flexibility is enhanced to pivot strategies or withstand industry shifts.
  • Attractive to buyers – Lower debt with better cash flow may improve valuation if selling the business.

In Summary

All small business owners likely wish they had lower debt payments and more cash freed up for growth and operations. Carefully directing excess funds toward paying down debt faster is one of the best ways to accomplish this goal over the long-term. Just be sure to prioritize the highest cost debt first while balancing the other considerations covered above.

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