The 30% interest rate on their small business credit card shocked James and Heather Hills enough to stop using it entirely in April. The couple had turned to credit cards in early 2006 to get their Elgin (Ill.) startup, mhn Internet Marketing and PR, off the ground, after three loan officers told them that they wouldn't qualify for a bank loan without capital equipment to put up as collateral. So the Hills, who have no outside employees, took out a $50,000 home equity line of credit and two personally guaranteed small business credit cards.
They had a handle on their debt until a partner abandoned a planned joint venture in March 2007 and the Hills were left with almost $10,000 for the project on their Advanta (ADVNA) card. Since then, they say they've been late on a couple of payments, and their interest rate has steadily increased from 11.74% to 30.99%. "It suddenly starts being several hundred dollars worth of interest charges," James Hills says. Even without new purchases, they don't expect to pay off the remaining debt, still over $6,000, before 2009. (Advanta, citing privacy laws, declined to comment.)
Expensive Seed Money
While data on small business borrowing is scattered, indications show that entrepreneurs are increasingly relying on credit cards to finance their businesses, especially early-stage companies. The percentage of firms using credit cards has jumped from 16% in 1993 to 44% today, according to surveys by the National Small Business Association, a trade group. In the same period, the proportion using bank loans dropped from 45% to 28%. A Federal Reserve survey showed that the percentage of firms using business credit cards jumped from 34% in 1998 to 48% in 2003. And numbers from the NSBA and the Fed show that between 20% and 30% of all small businesses carry a revolving credit-card balance, rather than paying their bills in full each month.
"We don't have an alternative right now," says NSBA chair Marilyn Landis, a former bank executive who now runs Basic Business Concepts, a financial consulting business. "If there were alternatives, business owners would go there." It's a particular problem for service or information companies that don't have equipment or inventory to secure commercial loans. In testimony before the Senate Small Business Committee in April, Landis described applying for bank lines of credit and receiving credit cards instead. But relying on cards, rather than on fixed-rate loans or credit lines, can saddle small companies with unexpected and expensive debt.
A Growth Market for Credit
Over the last decade, credit-card companies have courted small business owners as issuers try to expand beyond the saturated consumer card market. Some 12% of the 6 billion credit-card offers mailed each year promote small business credit cards, according to Mercator Advisory Group, an industry researcher. That's 720 million offers, or roughly 26 for each small firm in the U.S. "As issuers have discovered the small business segment, they have become fairly aggressive about getting small business cards into the hands of some very early-stage businesses," says Mercator analyst Ken Paterson.
That's because credit-card companies see small business as a fertile growth market. Visa (V) estimates that total small business spending in the U.S. hit $4.
7 trillion in 2007, but the volume charged on small business payment cards (including debit) is just $283 billion, according to Mercator's estimates. "As the bank card networks are fond of pointing out, there is plenty of room for growth just in displacing check volume," Paterson wrote in his report.
And more than other small business lending, the business credit-card market belongs to big banks. In 2005 the top 10 U.S. banks controlled 83% of the small business credit-card market, according to a report by research firm TowerGroup (which is owned by MasterCard (MA)). The same banks had just 32% of the Small Business Administration loan market (BusinessWeek.com, 5/14/08) and 14% of other small business lending. The shift has become more pronounced over the past year as banks battered by risky mortgage loans tighten lending standards.
In Lieu of Traditional Bank Loans
For some business owners, the easy access to credit-card debt does indeed provide crucial funding. Chris Mauzy applied for a bank loan last fall to start Zip Express Installation, a home electronics installation service. But the bank turned down the Minneapolis entrepreneur because he had no capital equipment to secure the loan, even though the loan officer was impressed by his business plan and experience as director of business development for Best Buy (BBY). "They were looking to fund a farm or a machine shop or something that is more traditional," he says.
So Mauzy got two American Express (AXP) business cards with no preset spending limit and began charging up to $30,000 to advertise and build a Web site. He paid the full balance each month as sales rolled in, and by the end of the year he had convinced an angel investor to fund him. In July, Zip Express closed a deal to provide installations nationwide for Target (TGT), and Mauzy expects to do $5.5 million worth of business in his first year. In retrospect, he says he's glad the bank turned him down, because doesn't have to pay the interest on a big loan.
While Mauzy is a success story, business owners who depend on credit cards for longer periods can get caught in the cards' slippery terms. "Credit-card contracts are not [traditional loan] contracts," says Landis, because unlike bank loans or lines of credit that are governed by loan agreements, credit-card issuers reserve the right to change the terms at any time. According to the NSBA's survey, a third of businesses using credit cards carried monthly balances of more than $10,000. Landis says unpredictable interest rates on large balances make it impossible for business owners to finance growth with credit cards. She saw rates on one of her cards go from 4% to 28% and another card reduced her credit line, even though she didn't miss minimum payments or exceed her limit. "It's like trying to build a house with blocks that keep changing shape," says Landis.
Those carrying revolving balances also pay more to borrow. David Walker, a Georgetown professor researching the cost of credit for small businesses, found that smaller firms typically pay two or three times the prime rate, largely because they depend so heavily on credit cards. "They're shut out of all the markets that are lower cost," he says.
That makes sense to a certain extent. Small businesses are risky, and lending through credit cards allows banks to cover their risk by adjusting interest rates as the borrowers' credit profile changes. "This is the riskiest form of loan a bank can make. They have to charge money to get a return on that risk," says Ken Clayton, senior vice-president for card policy at the American Bankers Association, the industry trade group. "If this were a traditional loan that had collateral that backs it, it would be a lot easier to lock in rates."
Reining in Abuses
Regulations proposed by the Fed would rein in some of the most aggressive credit-card practices, including changing rates on existing balances and applying payments in ways that maximize interest charges. But the changes would apply only to personal credit cards, not the growing number of small business cards, even though they often function the same way.
James Hills says he is still shocked when he looks at his books to see how much credit-card debt has cost his business. "Even though we pay quite a bit, they keep raising the interest rates, which makes it even harder to pay off," he says. "Virtually tripling the interest rate from the starting rate to now, that's just amazing that they're able to do that."
For a look at credit cards with the most market share targeted at small business owners, flip through this slide show.
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