What is debt financing? 10 advantages and disadvantages

Debt financing is a way for businesses to raise capital by borrowing money—typically with interest—without giving up ownership of the company. This financial strategy can open the door to new business opportunities, but it also comes with its own set of risks.

Keep reading to learn more about the advantages and disadvantages of debt financing to determine if this type of financing is right for your business.

What you’ll learn:

• Debt financing is a business funding strategy that enables businesses to borrow capital from lenders through bank loans or bonds. This means the lender becomes a creditor and the funds must be paid back with interest.
• Business owners maintain company ownership with debt financing, whereas equity financing involves selling shares of ownership to investors.
• Types of debt financing include loans, lines of credit, bonds and notes, equipment financing and more.
• Advantages of debt financing include gaining access to cash to help fuel business growth and the ability to potentially deduct interest paid from your taxes.
• Debt financing might not be ideal for all businesses because of the potential for higher interest rates, the need for steady cash flow and possible collateral requirements

Debt financing is when a business borrows money from a lender and agrees to repay the amount with interest. It can include various types of lending, but in all cases, the business retains full ownership of the company.

Debt financing and equity financing, the two main avenues of business funding, differ in how capital is raised. Debt involves borrowing money that must be repaid with interest, while equity involves selling ownership shares in exchange for funding.

With debt financing, businesses retain full ownership of the company but must make regular payments, whereas equity financing doesn’t require repayment but gives investors partial ownership and often a say in decisions. Businesses may use one or both types of funding strategies when seeking additional capital.

Debt financing allows businesses to borrow money from a lender and repay it with interest according to an agreed-upon schedule, with no transfer of ownership. The interest rate available to a given company may depend on its creditworthiness, including its business credit score.

The process of acquiring debt financing may vary based on the type and lender. Generally, though, it follows these steps:

1. The business applies for financing, often submitting financial statements and a business plan.
2. The lender assesses the application and may approve it based on factors such as credit history and collateral.
3. If approved, the lender provides loan terms, including the interest rate, repayment schedule and any fees, which the business must review and accept.
4. The lender disburses the funds to the business as a lump sum or a credit line.
5. The business repays what it borrows, plus interest, per the agreed timeline.

Common types of debt financing include loans, lines of credit, credit cards, bonds, and other funding options that allow businesses to borrow money and repay it with interest. Each type serves different business needs, depending on factors like funding amount, flexibility, repayment terms and how quickly funds are required. These options include:

• Business loans: Business loans are often structured as term loans that can be used for working capital or major purchases. They may range in available amounts, interest rates and repayment timelines.
• U.S. Small Business Administration (SBA) loans: Partly guaranteed by the U.S. Small Business Administration, SBA loans often offer competitive interest rates and reduced risk for lenders, but the application and disbursement process can take longer.
• Business lines of credit: A business line of credit provides access to a flexible set amount of money that a business can borrow from as needed. Instead of owing interest on the full amount, it only needs to repay what it uses plus interest.
• Business credit cards: A type of line of credit, business credit cards allow businesses to spend up to the card limit, with interest charged on any unpaid balances.
• Bonds and notes: Businesses may sell bonds and notes to investors to raise funds, with the promise of repaying the principal with interest in the future. 
• Invoice financing: This type of debt financing involves selling or borrowing against unpaid invoices to a third party for a portion of their value. It can provide funds more quickly, but often at a higher cost.
• Asset-based lending: These secured loans require collateral like inventory or equipment and generally offer lower interest rates. The loan amount is typically based on the value of the asset.
• Equipment financing: Equipment financing provides funds to businesses that need to purchase items like vehicles, machinery or technology, using the equipment as collateral.
• Merchant cash advances: This refers to a lump-sum payment made to your business in exchange for a percentage of future credit or debit card sales.
• Trade credit: This is a type of short-term debt financing offered by suppliers that allows businesses to make a purchase immediately but pay later—typically 30 or 60 days after the transaction. This can be helpful for businesses that need time to manufacture products and generate revenue before paying the invoice.
• Convertible debt: This type of financing—sometimes referred to as a convertible bond—is considered both debt financing and equity financing because it involves converting a loan into equity shares in your company.

Different types of debt financing may be better suited for short- or long-term needs. Short-term debt financing options like lines of credit or invoice financing may be best used for operational expenses and other ongoing, smaller needs. Meanwhile, long-term debt financing types like loans and bonds can be better suited for larger expenditures, like capital investments.

Debt financing can support business growth, preserve ownership, offer potential tax benefits and help build business credit. While you might think of debt as a bad thing when it comes to personal finances, having some form of debt can actually be a good thing if it fuels business growth. Here are some of the advantages of debt financing.

You can use debt financing methods to expand your business, whether for the short term or the long term: 

• Short-term debt financing can be instrumental in improving cash flow and generally needs to be repaid within a relatively short period, often a year.
• Long-term debt financing can be used to purchase larger assets, is paid over an extended period of time—which may span several years—and can have a fixed interest rate and equal monthly payments.

Because interest paid on debt is often considered a business expense, interest paid is tax deductible in most cases. This means you can deduct payments made toward interest from your business’s income at tax time.

If you want to retain control of your business, you might choose debt financing over equity financing. Rather than partner with investors who would get a stake in your company, you would borrow the funds from a lender and repay them over time with interest. This allows you to retain full ownership and remain the primary decision-maker in your company.

When you use debt financing to stimulate growth, your lenders may report your activity to business credit bureaus, which you can use to build business credit with responsible payment habits. Building business credit can yield better interest rates and repayment terms on future loans or lines of credit, which may support continued growth.

And if you’re a new business owner or sole proprietor who uses your Social Security number to secure a business credit card for debt financing purposes, responsible use could positively affect your personal credit.

Certain types of debt financing can have lower interest rates, but the options available to your business can vary by lender. For example, SBA loans are government-backed and typically offer longer repayment terms—and more competitive interest rates—than conventional loans.

Debt financing can come with stricter qualification requirements, repayment obligations and potential financial risks that businesses should carefully consider. While debt financing can be a strategy to help your business grow, here are some considerations to keep in mind before you leverage debt for your company.

Depending on the lender and the type of debt financing you’re trying to secure, you may need to meet certain criteria, like:

• A minimum level of business revenue
• A specific credit score threshold
• A minimum time in business

Understanding the eligibility requirements before applying for credit can help you get a better idea of what you may qualify for and which options to pursue.

Because debt financing typically requires regular payments on the principal and interest, lenders often require a consistent cash flow or source of income. This may be difficult for businesses with seasonal revenue or startups with fluctuating income.

Before you’re able to take out a business loan or line of credit, you may need to pledge collateral to lenders. This protects the lender if you were to default on payments, because the item you use as collateral could be seized and sold to recover any losses.

For example, equipment financing lets business owners borrow funds to purchase business equipment, such as machinery or vehicles, which serves as collateral for the loan.

While debt financing can help build credit, it can also negatively impact your credit score if you don’t make payments on time. This could hurt your ability to borrow funds in the future and affect the loan terms you receive. That’s why it’s important to establish a plan to repay your business debts on time while maintaining healthy cash flow.

Certain types of debt financing can come with higher interest rates. Before you secure any type of financing, be sure to understand the total cost of borrowing by reviewing the interest rate, APR and loan payments.

Debt financing is one way to help expand your business, but the way you leverage debt can depend on your company’s specific needs and goals. One popular debt financing option is using a business credit card to gain access to funds that you can use to stimulate growth. Capital One offers a variety of business credit card options, and you can get pre-approved to see which cards you may be eligible for—without impacting your credit.