Should You Take Out a Loan for Payroll?

Should You Take Out a Loan for Payroll?

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When cash flow slows, becomes stagnant, or is otherwise disrupted (large purchases, overdue accounts, etc.), business owners can become vulnerable to a variety of financial woes. Bills can go unpaid, vendor relationships can become strained, and, if the problems persist, your credit can take a quick slide downward. Unfortunately, cash flow problems can also impact another essential part of your business – payroll.

Aside from leaving employees disgruntled, failure to meet your payroll obligations is considered a violation of the Fair Labor Standards Act (FLSA), which can result in penalties handed down from the Department of Labor.

But what can you do if you don’t have the cash to make payments? Should you take out a loan to cover payroll?

The answer to that depends on a variety of factors, including your legal obligations to employees, but before you make the decision to take out a loan, ask yourself these questions:

Why can’t you make payroll?  

Though the exact reason for payroll problems can vary from business to business, there are typically two primary circumstances that leave business owners frantically trying to make good on this obligation:  changes in cash flow or unexpected expenses.

Whether it’s a slow season or a general decline in business, when you’re not bringing in enough money to make the bills, each pay cycle can become a source of dread. If your cash flow issues have become a trend, a loan, specifically an alternative short-term loan, can compound issues, leaving you vulnerable to high-interest rates and increased debt. If that’s the case, then you may want to consider some other options first, which we’ll discuss shortly.

If, on the other hand, your inability to make payroll is an unexpected blip due to immediate equipment repairs, seasonal staff ramp-ups, etc., and you’re confident that you can pay back the loan quickly (sometimes by the next pay cycle, depending on the loan), then a payroll loan can be a reasonable solution to a momentary problem.

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Do you have unpaid invoices?  

If your business model includes a reliance on invoices, and if those invoices go unpaid, meeting financial obligations can be difficult. However, before you jump into a loan, make an honest attempt to collect on any outstanding accounts.

If clients are unwilling to pay their past-due balances, you may want to consider offering a small discount in exchange for immediate payment. This may encourage them to pay up and allow you to collect enough cash to pay your employees.

What if you can’t get them to pay? In some cases, you can take out a line of credit or access capital through invoice financing. In this scenario, you receive a cash advance on a percentage of the outstanding invoice value (typically 85%). Once the invoices are paid, the lender gives back the remaining amount minus a fee.

Do you have a line of credit?  

If you already have a line of credit with a bank, alternative lender, or credit card, you may be able to use it to finance payroll.

If you have access to a line of credit through your business credit card, be sure to take note of the interest rate as well as any fees you’ll incur. In some cases, the APR can be higher than your purchase APR and/or you may be required to pay a one-time draw fee.

Do you have good relationships with your vendors?

There are plenty of reasons you should build strong relationships with your vendors or suppliers, and this is one of them. In some cases, you may be able to ask for a short extension, allowing you to pay your bill a couple of days or weeks later. This could temporarily free up the cash you need to make payroll.

Of course, it’s not advisable to make that request frequently, as it can quickly turn your relationship sour. Similarly, this also isn’t a good option if you’re not confident you can repay them in accordance with the extended term.

Using a Loan for Payroll

Sometimes a loan represents your only means to meet your payroll obligations, and if that’s the case, it’s important that you’re honest about your financial needs as well as your ability to repay. Failure to do so can make your financial situation even more complicated.  

Can you repay a loan quickly or will you need a long-term solution? How much do you need to borrow? What’s your credit score?

The answers to those questions can help guide you towards the best solutions for your specific circumstance. For example, if you need the cash immediately, a short-term loan through an online lender may be your best option – though it won’t necessarily be the cheapest.

If, however, you anticipate upcoming or long-term issues that will impact your ability to pay employees, you may need to look into a solution that will accommodate that need, like a business line of credit. In this case, you’ll have access to revolving credit that you can use as needed, only paying for (and accruing interest on) what you’ve borrowed.

Though taking out a loan to finance payroll isn’t ideal, it’s often a necessary evil that many business owners need to deal with.  You need to pay your employees, and though you may be able to placate them for a few days, the impact it can have on workplace morale when paired with the potential legal ramifications you may face, can lead to even bigger problems.

Before you take out a loan for payroll, always make sure you’ve considered all your options and if a loan is the only way out, then thoroughly review your financial needs and your ability to repay according to the lender’s terms.

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About the Author — Jennifer is a alum of the University of Denver. While in the graduate program there, she enjoyed spending time identifying ways in which non-profits and small businesses could develop into strong and profitable organizations that while promoting strong community growth. She also enjoys finding unique ways for freelancers and start-up businesses to reach and expand their goals.

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