For many small business owners, loans are a way to finance startups and expansion. Eventually, you might have an opportunity to refinance a higher interest loan into one with a lower interest rate or better terms. Refinancing might lower the cost of borrowing over time or free up cash flow that you can use to grow the business.
But refinancing isn’t always the best choice. In fact, sometimes it can do more harm than good.
4 times you shouldn’t refinance your small business loan
When you refinance a loan, the debt doesn’t go away. You just repackage it into a new loan – hopefully with a lower interest rate or more favorable terms. But before you do, consider whether any of these red flags pose a concern.
You can’t afford the fees
Refinancing a small business loan is essentially like taking out a new loan, and it comes with fees. While fees vary from lender to lender, some common fees associated with small business loans include:
- Application fee. The lender may charge a fee to process your application and check your credit. An application fee covers these costs.
- Check processing fee. If you make loan payments via check, the lender may charge you a monthly fee to cover the time and effort it takes to process it. You may be able to avoid this fee if you make payments via electronic funds transfer (EFT).
- Guaranty fees. Loans backed by the U.S. Small Business Administration (SBA) may require upfront and monthly guaranty fees. The fees vary by program, loan amount and maturity. For the 2021 fiscal year, the SBA 7(a) loans charge 0.55% of the guaranteed portion of the outstanding loan balance annually and an upfront fee ranging from 0.25% (on loans that mature in 12 months or less) to 3.75% of the guaranteed portion for loan balances over $1,000,000.
- Origination fee. Lenders use origination fees to cover other administrative costs of finalizing a small business loan.
While refinancing your small business loan might result in lower monthly payments, you need to make sure the fees don’t outweigh the benefits.
Your credit score is poor
Your business credit score and personal credit score can have a huge impact on whether refinancing is worth the time and cost. If you have a good credit score, you may be able to lower your interest rate when you refinance. However, if your credit has taken a hit — perhaps from a history of late payments — you may struggle to find a lender willing to help you refinance.
Lenders typically don’t offer the lowest rates to borrowers with credit scores below 600. So the amount you’ll be able to save on your monthly loan payment may be minimal, and it will take longer for you to break even on the loan’s closing costs.
In that case, it might be wise to hold off on refinancing until you can build your score back up.
If you want to see whether you might be eligible for a rate reduction start by running the numbers and doing some research. Think about your business, your estimated credit score and existing loan information, all important considerations in helping you decide if refinancing is the right move.
You’re considering bankruptcy
The pandemic put a lot of financial pressure on small business owners. According to the Federal Reserve’s 2021 Small Business Credit Survey, 78% of small business owners reported a decrease in revenues from 2019 to 2020, and 46% had to reduce their workforce.
If you’re struggling to pay your debts, employees, utilities and other expenses, refinancing your small business loan might seem like a smart option. And it can be if refinancing improves your cash flow and helps you avoid bankruptcy. But sometimes it’s not enough.
If you refinance and wind up filing for bankruptcy within 90 days, the bankruptcy trustee might investigate the refinancing. If the trustee determines you shouldn’t have refinanced the debt, they have the power to cancel the transaction retroactively.
For example, say you have a loan from the same business that handles your business checking account. You’re considering bankruptcy but don’t want to risk damaging the relationship with your bank. If you refinance the loan with another lender, then file for bankruptcy, the trustee may consider the refinance to be a “preferential transfer,” and the trustee can “clawback” the transaction.
The time frame for clawing back preferential transfers would extend to a full year before the bankruptcy filing if the refinancing benefited an “insider,” such as a close friend or family member.
If you’re considering bankruptcy and want to refinance your small business loan, discuss the issue with an experienced bankruptcy attorney. They can help you navigate the bankruptcy laws in your state and avoid preferential transfers.
Your loan includes a prepayment penalty
Some lenders charge a prepayment penalty to prevent borrowers from paying off a loan too early. This helps protect the lender from losing money in interest charges when you pay off or refinance your loan balance before it’s due.
If your loan includes a prepayment penalty, it may be a flat fee or a percentage of your outstanding loan balance. Some lenders have a step-down penalty, where the percentage gradually declines over the loan term. For example, they might charge 5% of the outstanding loan balance if you pay it off in the first year of the loan, 4% in the second year of the loan, 3% in the third year of the loan, etc.
If your existing loan has a prepayment penalty, it should be disclosed in the loan documents. If you can pay the penalty and still end up saving money on interest, refinancing may still be a good move. But it’s important to consider that prepayment penalty in your calculations.
Refinancing a business loan can have its advantages. However, lowering your interest rate doesn’t always mean it’s a good decision. Carefully consider all the pros and cons and crunch the numbers to determine whether refinancing will really save you money in the long term. Then you can be confident that you’re making the best refinancing decision for your small business.