When does debt turn into a debt cycle?

Oh boy, debt can be such a touchy topic for many. However, it’s not always a bad thing when good measures are taken, and there’s a good basis for it. There is one video or blog we’d like you to read, preferably before this one, to provide more insight and background on a few key points. There’s a third video/blog that follows this one, diving more into debt ratios, quick ratios, current ratios, and more.

So go look at “debt with your company, is it good or bad?” and follow this blog on debt cycles, with “what is the target debt ratio?” In this blog, we will dive into the good types of debts to accept and scenarios they work best with, what types of debt to avoid, and how cycles are created.

Lenders to Avoid

    There are lending companies out there that use attention-grabbing phrases that will sound cliché. “Guaranteed Approval, no credit check needed” suggests that everyone qualifies, regardless of credit. However, what this really means is they’re not evaluating risk–they’re planning to charge extremely high interest or fees to offset it. Why should this sound alarm bells to you? Legitimate lenders always assess the ability to repay.

One other common attention grabber is a headline that says, “Low monthly payments!” It may sound like “only $199/month,” but what it’s really saying is that they may be extending the loan term (typically leading to more total interest) and hiding a higher APR. This is a red flag because the focus is on the payment amount rather than the loan’s total cost.

Another common one we unfortunately see stressed business owners accept is consolidating loans. They might have been enticed by the phrase “consolidate and save thousands” or something along those lines.

These lenders’ intentions are to keep you paying the loan longer with more interest and fees, offsetting the savings. They make it look like you will pay a lower monthly payment for consolidating loans by rolling your debt into “one easy payment”.

Furthermore, scheming lenders usually combine 3 elements in their trap-style lending messages. Emotionally, they use words and phrases to elicit a sense of relief, urgency, or excitement in the reader. They will use simplistic words, like “easy”, “fast”, or “no hassle”, to portray that they will provide you with an easier route than going to the bank to take out a loan.

They always deliberately leave out the total cost, APR, or penalties to trap you in this debt cycle and keep you paying them. If you see all 3 of these characteristics in a message, email, or mailed letter, that should be a strong warning sign to not respond.

A practical rule of thumb is if it makes you feel rushed, unusually lucky, and relieved too quickly, it’s worth slowing down and reading everything twice. You will typically receive these messages when you click on sites for quick loans or when you recently applied for credit lines, because they try to bait people to open more debt.

A real scenario of a debt cycle

Here is a simple scenario of how the debt trap works, and we will use rounded numbers to simplify. Let’s say an HVAC company called Cool Air Services makes most of its money in summer and winter seasons but has slow periods in spring and fall. Their monthly expenses are about $40,000 (payroll, trucks, insurance, materials). Their slow season revenue is $25,000, leaving them short $15,000 a month.

To stay afloat, Cool Air Services decides to use credit to cover that gap. They decide to put expenses on a business credit card and take a short-term working capital loan. After the 3 slow months, their credit card balance is $30,000, and the loan balance is $20,000.

Now the busy months roll in, and revenue jumps, which is all great and dandy except that the loan and credit card balances have increased. Instead of keeping the profits from that revenue to build savings, it is now being used to pay off past survival debt. This becomes severely bad if a service truck needs repairs, such as a transmission failure. There were no reserves, so it gets paid off with a credit card or a loan.

Then the debt increases again, and this is how a debt cycle starts.

When to accept debt

Before making any final decisions on refinancing or consolidating loans, you must analyze the pattern that’s causing it. In most cases, it’s the scenario given previously, and for your company, you must diagnose the real problem, not just “we have debt that we must pay off”. Identify the cause cycle.

Are you charging low prices? Are you experiencing inconsistent sales—revenue gaps forcing borrowing? Is your overhead too high? Are you seeing inefficient operations, such as labor being too high and output being lower?

By understanding the root causes of your recurring debt before making decisions, you can create better habits and adjustments that may alleviate the company’s debt and overhead expenses, and then arrange for the current debt. “Managing Business Debt: How To Borrow Wisely and Stay Financially Strong” is a short article by PNC Bank that offers valuable insights into managing business debt.

Overall, using debt to get out of debt sounds contradictory—but in some cases, it can be the right structure. In others, it might just be best to pay off the current debt and avoid new debt. It can work for you if you’re in a situation where you have high balances on credit cards, each with an interest rate of 19% to 25% or more, and you pay off those balances with a 10% APR loan.

And if you find yourself in this debt cycle, refinancing can help, but it must at least lower the total interest paid, reduce the monthly pressure, and offer a clear payoff timeline. It must help eliminate a harmful type of debt and prevent re-borrowing. We recommend that you look into refinancing with a bank or credit union, as well as a line of credit.

Circling back to consolidating loans, this can be a smart move—but only under the right conditions. Otherwise, it can quietly turn into the same kind of debt trap we discussed. The #1 reason to consolidate is if your new loan will have a lower APR than your current debts.

This is because you pay less interest over time, and you can get out of debt faster, considering that you keep your payments steady. It can also help you if you’re juggling too many due dates/loan payments with different minimum payments.

The consolidation loan can reduce stress and protect your credit from missed payments. Consolidating loans works best if you have a clear payoff plan and you don/t add new debt afterward. However, you must commit to paying it down consistently. Otherwise, you risk consolidating… only to end up rebuilding the same debt.

Also, please be careful if a consolidated loan offer is using something important as collateral. If you struggle to pay it back, you could lose something critical, putting you farther back than you started.

Zooming out

    On the whole, when diving into cycles and specifically debt cycles, it’s quite easy to get into detail and “get in the weeds,” as I like to call it. You can quickly get lost in analyzing the cycle and fall into analysis paralysis, trying to figure out how it started and how to make changes to put your company on a path to growth.

At Waterford Business Solutions, we provide bookkeeping services and financial statements with financial advice that helps you see the margins in a fuller picture. This can help you avoid getting in the weeds and spinning your wheels on your own.

We can help you determine whether your pricing or overhead expenses need adjustment, or whether your company is experiencing inefficient operations. We can also help you weigh the options of refinancing or consolidating your company’s loans. Reminder to follow this blog with “What is the target debt ratio” on our blog page on our YouTube blog page.