Here's something a little different.
Many small business owners take on debt early in the company’s formation. This is a necessity to build inventory, build out a location, pay staff and contractors, and keep the business afloat in leaner months. At some point, the business will become profitable enough to start actually paying that debt down. And this is the moment where a business owner has a difficult decision to make: pay off that debt or invest the money.
Traditional thinking would be to pay off the debt and eliminate an obligation. This, in turn, will allow you to more aggressively save, invest, and expand later. Also, should you go through a time where the business is under financial stress, there is no onerous debt strangling you. For many, the prospects of a debt free business are too good to pass up, and for that reason they do not look beyond the debt reduction options available with that excess cash.
Another option, however, is to put that excess cash to work. This can be in the form of investing in the business or in non-business investments. For those who invest in the business, this can be in the form of expansion, additional advertising and marketing, exploring a new business line, or anything else that will lead to additional cash flow. They reason that the additional income from the sales will outweigh the cost of the debt in interest rate costs and monthly payments.
For those who look to external options, they may look at buying an ownership in another business, starting another business, buying real estate, or investing in the stock market. Each of these offers a unique way to turn that excess cash into much more money over time. Again, the reasoning is that the long-term growth of this money will outweigh the long-term cost of the debt obligations.
For some, the use of the cash for investments or expansion is the right idea. If you can make prudent decisions, your cash can grow exponentially. The debt, meanwhile, is a tax deduction, so the cost is actually less than the given rate, as you get some of it back in your taxes. The real way to calculate the best way to go is to figure out the true cost of the debt, which can be as simple as the annual interest cost minus the tax savings, and compare that to a projection of earnings on the cash used somewhere else.
So if you have a 3% interest rate, your effective cost would likely come out to somewhere between 1.9% and 2.4%, depending upon your corporate structure and tax bracket. So in most cases, you can outperform with your money elsewhere, allowing your money to work for you. If the debt is at 19.99%, on the other hand, then the true cost would likely be somewhere between 13% and 16%. This would be a harder number to beat with traditional investing methods (the S&P 500 averaged 7-8% per year in returns for the last 10 years and most real estate investors target 10-12% ROI). But a great business opportunity, or an opportunity to grow the business into a new area can easily yield returns that beat this cost. But remember, greater rewards usually come with greater risks.
At the end of the day, you need to determine what your costs are on your debt and what your growth will be on the money if you don’t use it to pay that debt off. If there is a clear ability to make money investing, then you would be better served maintaining the debt. But if there is some doubt about the value of the investment, then it’s never bad to be debt free.