Payroll Loans: How Do These Business Loans Work?

Payroll Loans: How Do These Business Loans Work?

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When a company is just getting off the ground, cash is often tight, which can make cash expenditures—such as employee payroll—problematic. Missing payroll can ruin employee trust and lead to a mass exodus of workers. Business owners may turn to financing in order to cover any payroll gaps.

How Do Payroll Loans Work?

A payroll loan is a short-term loan to help companies pay their workers in full and on time. This kind of loan is usually paid back quickly—usually within one year—and should not be used to finance long-term needs, as the interest rates can be steep. Short-term payroll loans are provided by commercial lenders. In many cases, the loans are unsecured and are made on the basis of the borrower’s creditworthiness. Companies that qualify for these short-term loans can receive funding as quickly as one day, with fixed daily or weekly repayments automatically deducted from the borrower’s bank account.

Alternatively, the borrower might secure the loan with a postdated check—dated for the end of the loan term, or due date—for the total amount of the loan and the interest charges based on the loan term. The borrower is obligated to pay back the loan by the due date. Failure to do so will cause the lender to cash a postdated check, and the borrower is responsible for any fees if the check bounces. You can expect the lender to charge substantial late fees and higher interest rates on delinquent loans.

Payroll Loans Rates and Terms

The following table summarizes average rates, terms and features of short-term payroll loans:

Loan Amount$5,000 – $500,000
Annual Percentage Rates10% – 50% or higher
Loan Terms1 – 36 months
Origination Fee2.5% – 5.0%, may be lower on repeat loans
Approval SpeedMinutes to a few days
Funding SpeedOne to three days
Collateral RequiredUsually no, but some lenders take a postdated check
Prepayment PenaltyNo

Why Would a Business Consider Payroll Loans?

Small businesses and startups often find it difficult to obtain financing from banks, due to poor credit scores, scant credit histories, or insufficient collateral. Although bank loans usually offer the lowest interest rates, they often take weeks to arrange. This will not work for business owners suddenly facing a cash crunch that threatens payroll. A commercial lender that offers short-term loans will charge higher interest rates, but it's more likely to approve and fund a loan quickly.

A payroll loan alternative that is favored by small businesses is factoring. In a factoring arrangement, the company sells invoices or accounts receivable to a finance company at a discount. Since the money advanced does not have to be repaid, this is not a loan. This kind of transaction is often more cost-effective than a short-term loan, especially if the borrower has a low credit score because the loan depends on the credit quality of the borrower’s customers, not the borrower’s.

How to Qualify for a Payroll Loan

Payroll lenders charge high enough interest rates to compensate them for the risk that borrowers will default. They set minimum standards to exclude the riskiest borrowers. Typically, a payroll lender will require the borrower to be in business for at least one year, and have annual revenues of $100,000. Business owners who have a personal credit rating below 500 will have difficulty being approved for a payroll loan unless they can produce a cosigner with a higher credit score.

When applying for a payroll loan, the following information will probably be requested:

  1. Social Security Number and Employer Identification Number
  2. Total business debts
  3. Recent bank statements and tax returns
  4. Financial statements

Where to Get a Payroll Loan

Payroll loan providers are usually commercial lenders who make short- and intermediate-term business loans or lines of credit. Business owners may want to consider invoice factoring if they have business or government customers, or a merchant cash advance if they have a lot of credit card receivables.

Online term loans and lines of credit: Short-term loans and lines of credit from an online provider—such as OnDeck, Kabbage, StreetShares or Fundation—can be a good option for payroll funding as it can close within a week and offer terms of one year or less. However, these loans have high annual percentage rates and frequent repayment—as often as daily or weekly. Qualifying is generally based on your personal credit score, time in business, and annual revenue.

Invoice factoring: If waiting for payment from your customers is the cause of your payroll problem, consider invoice factoring. You can receive an advance on an unpaid invoice. Qualifying is often easier, too, as it’s based more on your customer’s creditworthiness than yours. Companies like Fundbox and BlueVine will advance up to 85% or more of each invoice.

Merchant cash advance: A merchant cash advance (MCA) provider—such as Credibly or RapidAdvance—will fund you in exchange for a cut of your business’s future credit or debit card sales. Similar to the other options, MCA providers can close very quickly—meaning you can get funds within a couple of days. While MCAs carry high rates and require daily or weekly repayment, it’s generally easy to qualify for funding.

Justin is a Sr. Research Analyst at ValuePenguin, focusing on small business lending. He was a corporate strategy associate at IBM.