Launching a new business can be both exciting and fulfilling, but it’s not always easy to secure the funding you may need. Small business loans are one option, but they can be tricky to get. If that’s been your experience, you may find yourself wondering — should I take out a personal loan to start a business? The answer is a little complicated. Here’s when it’s wise to take out a personal loan for business, and the key aspects to consider before you do so.
Can I use a personal loan to start a business?
The short answer is that, yes, some lenders allow small business owners to use personal loans to kickstart a new business. Getting a personal loan is often quick and easy, and this approach allows you to secure funds based on personal creditworthiness rather than having to provide proof of your business history or assets.
However, using a personal loan in this way involves merging your personal finances with your business finances. If your business faces challenges, you’ll also see your personal credit report take a hit. Also keep in mind that some lenders put restrictions on the way you can use personal loan funds. Not all financial institutions allow borrowers to use personal loans for commercial or business purposes. Be sure to review the loan terms beforehand to make certain.
Business loans vs. personal loans: what’s the difference?
With both personal and business loans, you’ll get a lump sum of cash, which you’ll then pay back over time with interest. However, there are key differences between each type of loan.
Personal loans are typically used for personal expenses like debt consolidation, home improvements, or major purchases. On the other hand, business loans are specifically designed to finance business-related expenses such as startup costs, equipment purchases, or working capital.
Personal loans are generally based on an individual's personal credit history, income, and debt-to-income ratio. In contrast, business loans take into account the creditworthiness and financial history of the business itself, including factors like business credit score, revenue, and length of time in operation.
Loan terms and amounts
Business loans typically offer higher loan amounts and longer repayment terms compared to personal loans, allowing businesses to access more substantial funding over an extended period. Personal loans, on the other hand, usually have smaller loan amounts and shorter repayment terms.
Interest rates and fees
Business loans may have lower interest rates than personal loans due to the reduced risk associated with a business's higher revenue potential. Also, business loans may come with specific fees related to business operations or loan administration. Personal loans, on the other hand, may have higher interest rates and fees due to the higher risk associated with individual borrowers.
When borrowing a business loan, the business is typically held responsible for repayment. This means that if the business is unable to repay the loan, the lender's recourse is limited to the business's assets. In contrast, with a personal loan, the borrower is personally liable, and both personal assets and credit can be at risk in case of default.
Pros and cons of using a personal loan to start a business
Deciding whether to use a personal loan to start a business requires careful consideration of the advantages and disadvantages. Here are some factors to consider:
Pros of using a personal loan for starting a business:
Accessibility: Personal loans may be easier to obtain than traditional business loans, especially for individuals who don't have an established business or business credit history.
Flexibility: Personal loans can generally be used for any purpose, including starting a business. This provides you with the flexibility to allocate the funds as needed for various business expenses.
Speed: When applying for a personal loan, it’s not unusual to be approved in a single business day. On the other hand, a U.S. Small Business Administration or SBA loan, for example, can take as little as 10-14 days, or as long as 60-90 days to be approved for.
Cons of using a personal loan for starting a business:
Personal liability: When you use a personal loan for business purposes, you are personally responsible for the debt. This means that if your business fails, you are still obligated to repay the loan using your personal assets.
Higher interest rates: Though you might be eligible for a low-rate personal loan, in general, business loans have lower interest rates. Taking out a personal loan to start a business can increase the overall cost of borrowing.
Limited loan amounts: Personal loans don’t usually provide the same level of funding as business loans. Depending on the lender, you may be limited in the amount you can borrow, which could impact your ability to fully finance your business needs.
When does it make sense to borrow a personal loan instead of a business loan?
Taking out a personal loan instead of a business loan can make sense in these situations:
You have limited business history: If your business is in its early stages or lacks an established credit history, it may be challenging to secure a small business loan. In such cases, a personal loan might be more accessible.
You have strong personal credit: If you have an excellent personal credit score, but your business has relatively bad credit, lenders may be more willing to extend a personal loan than a business loan.
You need to move fast: Personal loans, which are often available through nimble online lenders, often require less documentation and have quicker approval processes than business loans. That makes personal loans ideal for businesses operating on tight timelines.
What do you need to qualify for a personal loan?
Specific eligibility requirements can vary among lenders. That said, you’ll likely need to have these things to secure a personal loan:
Good credit history: Personal loan lenders will issue a credit check before approving a loan. If you have a good credit score, you’ll have better chances of qualifying for a personal loan and may qualify for better interest rates.
Stable income: Lenders typically look for a consistent and stable source of income. This assures them you have the financial capacity to repay the loan.
Low debt-to-income ratio: The debt-to-income (DTI) ratio is the percentage of an individual’s gross monthly income allocated to debt repayment. A lower DTI indicates that you have sufficient income to cover your existing debts, along with the new loan.
Collateral: Secured loans may require you to put up collateral, such as a vehicle or savings account, to back the loan and reduce the risk for the lender. But if you go with an unsecured personal loan option, you shouldn’t need collateral.
What do you need to qualify for a business loan?
If you meet the following eligibility criteria, you’ll likely qualify for a business loan:
Business plan: Lenders often require a detailed business plan outlining your business model, target market, financial projections, and operational plans.
Good credit history: As with personal loans, a good credit history is crucial. Both the business and the business owner’s credit may be evaluated.
Financial statements: You may need to submit your business’s financial statements — including income statements, balance sheets, and cash flow statements — to establish its financial health.
Collateral: Secured business loans may require collateral — such as business assets, real estate, or personal assets — to back the loan.
Stability: Lenders often prefer businesses with a track record of stability and financial performance. As a result, it can be harder to secure funding for startups than for established businesses.
Personal guarantees: Entrepreneurs may need to provide personal guarantees, especially for small businesses or startups, making them personally responsible for the loan.
Are personal loans for business tax-deductible?
If you take out a loan for business-related costs, the monthly payments are not tax deductible, but the loan interest is. This applies not only to large businesses but also to freelancers or consultants with side gigs.
For instance, paying interest on a loan used to buy supplies to create a product or furnish a rental property could be considered a business expense. Therefore, you can deduct it from your taxes. Keep in mind that if you use a personal loan for both personal and business needs, you can only deduct the interest related to the business portion.
Alternative funding sources for starting a business
To avoid relying solely on loans, consider these funding options for your business:
Bootstrapping: This is the classic DIY approach. It involves using your own savings and any revenue generated by the business to fund its growth. This way, you maintain full control without accumulating debt.
Business credit cards or lines of credit: Like other credit cards, business credit cards offer a revolving credit line that allow you to make purchases up to a predetermined limit. That makes them ideal for day-to-day expenses. A business line of credit is a similar product, often available through banks and credit unions. A line of credit gives you access to a set amount of capital that you can draw upon when needed.
Angel investors: Some individuals are interested in investing their money in promising startups. These “angel investors” often provide valuable mentorship and industry connections as well as capital.
Venture capital: Aimed at high-growth startups, venture capital is a type of funding available from investment firms looking for substantial returns. In exchange for the cash injection, these firms typically take an equity stake in your business.
Crowdfunding: It’s becoming more and more popular to use online platforms to raise small amounts of money from large numbers of people. It’s an excellent way to validate your business idea and build a community around it.
Grants: Some government agencies, non-profits, and corporations offer grants to support specific industries and types of businesses. Grants typically come with fewer strings attached than other financing options.
Small business competitions: Many organizations and universities organize competitions where startups pitch their ideas. Winners often gain access to cash prizes or business support services.
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Having enough capital to operate and market your business can be the difference between success and failure. A personal loan can help you meet your business financing needs in the early days before the profits start rolling in.
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