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Financing your firm with a credit card? Bad idea

For every $1,000 in unpaid credit card debt, a start-up business increases the probability that it will close by 2.2% on average compared with having no such debt, a study shows.

August 18, 2009|Cyndia Zwahlen

Think twice before slapping down that credit card to cover costs at your new business.

The high cost of plastic credit can drag down growth at a young firm and increase the chance that it will fail in its first three years, according to a study conducted for the Ewing Marion Kauffman Foundation.

For every $1,000 in unpaid credit card debt, a start-up business increases the probability that it will close by 2.2% on average compared with having no such debt, economics researcher Robert H. Scott said in a report released this month.

"Relying on credit card debt is very expensive and makes these businesses financially unstable," said Scott, assistant professor of economics and finance at the Leon Hess School of Business at Monmouth University in New Jersey.

Yet almost 6 out of 10, or 57.9%, of the nearly 5,000 firms in the study used credit card debt to get started. The report looked at credit card use by the businesses in 2004, the year they all got going, through 2006.

The negative effect is probably higher today because credit card interest rates and fees have climbed dramatically while credit limits have been chopped. Even mainstream card companies are charging rates of 30% or more in some cases.

At the same time, more small-business owners are relying on plastic to start a business or fund an existing operation because other sources of money have dried up.

Christina and Thomas Kelly are one example. The couple opened their second Nutrishop franchise location in Orange County last year and expect combined sales of $500,000 this year. They tried to get a bank loan of $20,000 to $40,000 to help buy and stock the Huntington Beach store but were turned down repeatedly. Bankers wanted to see three years of profits, but their first shop had been open just two years, Christina Kelly said.

The pair ended up paying 50% interest on an $8,000 loan from an alternative lender just to get the doors open, she said.

Payments of $800 to $1,300 a month have gobbled up much of their cash flow this year, forcing them to charge up their personal credit cards to buy products to stock shelves at the new location and the original Seal Beach store.

Paying on the credit cards, along with a 10% drop in sales this year, has squeezed cash flow. It hasn't helped that one of their cards was canceled before they were notified, though their payment record was steady. A letter last week informed them that the rate on another card would now be 30%, up from 21%.

"There is no breathing room," said Christina Kelly, a mother of two who quit her full-time job with benefits to work at the stores to save on labor costs.

For many small-business owners, relying on credit card debt can turn into a death spiral, especially these days, said Sharon Peterson, a consultant at the nonprofit Small Business Development Center at El Camino College. The center is one of 38 statewide that offer free counseling, low-cost workshops and loans for small and mid-size firms.

"They are stuck in an endless cycle," she said.

Last week the consultant met with a business owner with almost $100,000 in credit card debt who wanted to get a loan to pay it off. Even if the owner had been able to qualify, many lenders don't let a borrower use more than 20% of the loan amount to pay off other debt, Peterson said.

Another business owner she met with recently has rung up more than $100,000 in credit card debt trying to stay afloat. She used her 401(k) money to start her business years ago and is now running out of resources. The owner was searching for a business loan but won't look very attractive to banks, the consultant said,

Bret O'Connor, director of the Small Business Development Center hosted by Long Beach Community College District, said his team also is seeing more small-business owners coming through the doors in dire straits, looking for loans but hampered by thousands of dollars in credit card debt.

"People who could maybe have eked by before are going under," he said.

Communities take a hit when their small businesses fail, said Scott, the author of the credit card study.

Even a business with just a handful of employees, and most have fewer than that, can be a tiny economic engine buying supplies and paying rent and a wide variety of taxes, including contributing to the state unemployment insurance fund.

Employee pay also pours cash into the local economy at grocery stores, gas stations, hair salons and the like, as well as into the federal Social Security fund.

Scott is not advocating that every small business with burdensome credit card debt be saved. But he would like to see more alternatives to costly credit card loans.

One option he suggested: more micro bank loans for less than $25,000 with a guarantee by the federal Small Business Administration. SBA interest rates typically have been higher than those of conventional bank loans because they often go to riskier borrowers, but the rates usually are lower than alternative financing.

The SBA has at least one pilot program, the Community Express loan guarantee, that focuses on such smaller loans, but it has been plagued by relatively high default rates, among other issues. The agency's American Recovery Capital loan program can provide up to $35,000 in a short-term, interest-free loan for a viable small business, but the program is temporary, isn't offered by all SBA-approved lenders and is available only until funding runs out or Sept. 30, 2010.

Scott encourages policymakers to boost small firms' access to micro loans and to add small-business credit cards to future card reform legislation.

"If we can save 2%, 3%, 5% -- maybe even more -- of those businesses who would have closed, by offering them a cheaper loan and still at a good interest rate for the taxpayer," Scott said, "that's a net positive for everybody."

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smallbiz@latimes.com

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