Should your business or nonprofit repay its loan early at its first opportunity?
A business-owner colleague reached out to me saying that he had nine months left to his three-year loan. If he stretched himself, he could pay off the remaining loan early. On the flip side, paying off his debt would wipe out any financial cushion he had for about 30 days, in other words, until his next billing cycle.
It’s important to point out that this owner’s forecasts didn’t predict any difficulties keeping to the monthly repayment schedule. Additionally, the loan’s interest at this point was negligible and, thus, also not a factor in his thinking.
Rather, stumping this owner was uncertainty if there was an inherent benefit to repay loans whenever possible.
CREDIT FOR YOUR BUSINESS IS NOT INHERENTLY EVIL, BUT…
Credit is one of the most important financial tools in an organization’s arsenal. Its benefit to help grow a business is potentially miraculous, while its latent risk to decimate even the private life of a business owner cannot be understated.
Therefore, while using credit is not inherently wrong, you need to be certain that using a credit product is warranted and that you’re utilizing the right credit solution.
Taking that all in, it is no surprise that both private individuals and organizations will find themselves asking if they should erase debt whenever possible.
(For more about Credit, see previous articles about Types of Credit and the Difference between a Bridge Loan and a Line of Credit.)
It’s critical to remember that while the bank is motivated to lend money to businesses that can repay their loan, the bank’s criteria and priorities are not the same as the borrower. Do not expect the bank to look out for your best interests or to help you ascertain if credit is the best thing for your venture.
KEEP THE LOAN: CREDIT CAN BE A GOOD THING
1. Does Repaying the Loan Put Your Company in Jeopardy?
While this wasn’t the case here, if paying the loan early puts your organization in jeopardy, meaning that in a few months you might have to go back to the bank for another loan or line of credit, then repaying certainly isn’t doing anything for you.
Again, credit is not inherently evil. Moreover, incoherent communication with bank about your credit needs does not present the most solid business or loan candidate. And while much of the bank’s decision relies on numbers, trust is still an important part of the loan process.
2. It Takes Money to Make Money
If we’re talking about an individual, one of the key indicators will be if the money is being invested in ways where the return is higher than the interest of the loan. If it will earn you more money, then keep the loan.
Think of someone who obtains a mortgage on his house at a fixed rate of 6% to invest in a real estate project that will earn him 9%. Obviously, there’s a lot to consider before making an investment, but from a strictly math perspective you can understand see how this opportunity is financially interesting (especially when mortgage rates were super low after the global financial crisis).
Companies and nonprofits can face a similar quandary, though their investment opportunity is in human capital, marketing, and equipment rather than using the credit/loan to participate in other financial investments.
For example, you might take a loan for your business to hire additional employees because you know that it will take some time before your company’s income can support the increased staff.
However, with that said…
GOOD REASONS TO REPAY LOANS EARLY
1. Being in Debt is Simply Nerve-Wracking
Carrying debt can be a worrying thing. There are people who on principle will not go in to debt as using money they do not actually have scares the heck out of the them (pardon my French). As well as it should. Especially here in Israel, 11 times out of 10 you need to sign a personal guarantee for your organization’s credit.
2. Build Trust with Your Bank
Paying off debt early is also a great way to show the bank that you are a good customer and can increase the chances of getting credit again in the future and potentially in larger amounts, should you need it.
THE BEST REASON: CREATING A NIMBLE BUSINESS
One of the most important tools to create a agile business is to limit the amount of fixed expenses that your organization has. Simply put, if you need to cut expenses tomorrow, what items could immediately go and what expenses are you stuck with.
Strangling Debt Commitments in Practice:
In my previous article, I demonstrate that the similar best-practice principles exist in every organization, no matter the sector and regardless if one is a for-profit and the other is a nonprofit. As the author Jim Collins writes, “Great business corporations share more in common with great social sector organizations than they share with mediocre businesses.”
Below are varied examples that demonstrate the dangers of debt and loan repayments.
- There was a fascinating podcast about American colleges, who in their pursuit to recruit more students, are continuing to borrow above their means – with expenses still outpacing tuition and enrollment. A good number of these institutions now have 10% or more of their budgets committed to paying off debt. Yikes.
- This is also at the heart of the continued debate surrounding the budget of the United States. The Pew Research Center reports that “payments on the debt are estimated to total $393.5 billion this fiscal year, or 8.7% of all federal outlays.” (Additional information on the challenges facing the US budget can be found in this primer here.)
- Israeli nonprofits encountered a similar problem after the global financial crisis of 2008. A number of the bigger and more famous charities took on capital/building projects or loans predicated on a combination of the high number of donations received at that time and the then high Dollar/Shekels exchange rate –both of which took a hard hit with the recession. With promises made and contracts already signed, these charities were scrambling to close their deficits. Not all of them made it.
Again, the more financial “promises” you’ve made, the harder it is to shift money to more lucrative ideas, or reduce spending if sales/donations unexpectedly slow down.
The question boils down to whether you can predict the next 30 days versus predicting the next six months.
If the immediate future objectively looks good, or even subjectively when compared to the more long-term, then paying off debt could be the right decision for you. That financial independence could give your company or charity a degree of flexibility that might be critical if your forecasts unexpectedly change or a valuable opportunity suddenly arises.
In the future, we’ll speak of other ways to reduce financial risk and how to create a nimbler enterprise. I look forward to hearing your thoughts.
If your business or charity operating here in Israel is thinking about applying for credit or is looking manage their existing credit or cash flow, speaking the issues out with an objective third party can be really helpful. As always, all introductory meetings with us are free and with no strings attached. We look forward to hearing from you.