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
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
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
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
- 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.
5. Failing to shop around for financing
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?
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.