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Starting a business isnât for the faint of heart. As the saying goes, âEntrepreneurs are people who quit their 40 hour a week jobs working for someone else, so they could work 70 hours a week for themselves.â But the dream is to make enough money and find enough freedom that those long hours donât even matter, right?
To get to that point, many soon-to-be small business owners find themselves in need of securing capital to get their company started. This raises a question: Should you use personal loans to start your company?
Weâll get to that and more by the end of this article.Â
How do personal loans work?
Most personal loan options are term loans, where the borrower is approved for a maximum credit limit, receives a lump sum payment upfront, and then repays the loan over time. The repayment terms for personal loans include the amount of money borrowed and financing charges, which include an interest rate and loan fees. The interest rate on personal loans can be fixed, where it remains the same over the length of the loan, or it may be variable, where the rate fluctuates month-to-month depending on the market rate.
Funds from personal loans can be used to make large purchases, for debt consolidation, to cover unexpected expenses, and even to start a business. Some borrowers prefer to take out a personal loan over using a credit card for startup costs because the interest rates are lower. According to the U.S. Central Bank, or Federal Reserve, the average interest rate on personal loans as of August 31, 2022, is 10.16% and the average rate for credit cards is 18.43%. Personal loans are also preferred over using personal savings to open a business because they carry less risk for the borrower. Small business loans offer better repayment terms than personal loans, but some new business borrowers struggle to get through the business loan application process.
How to get approved for a personal loan?
The eligibility requirements for personal loans will vary depending on the lender you work with and the loan amount you are applying for. The first step in exploring the best personal loan is to research a few lenders. You can find lenders with an online search or by asking friends and family for referrals. It is important to find a lender that approves personal loans for business purposes and will work with your creditworthiness.
To approve borrowers for a personal loan, lenders will evaluate the following factors:
- Personal credit score â Credit scores range from 300 to 850, with a higher score representing a higher likelihood that the borrower will repay the loan in full, making them a lower risk for lenders. Credit scores under 620 are considered bad credit and create a challenge for borrowers, while scores above 700 are considered good credit. Credit scores, also called FICO scores, are calculated based on the borrowersâ payment history, open accounts, credit inquiries, available credit, and length of time accounts remain open. If you donât know your personal credit score, you can obtain a free copy of your credit report before applying for loans.
- Other outstanding debt â Lenders will review any other debt you may already have when considering you for a new personal loan. Lenders and underwriters use your current debt schedule and the amount of money you are making to calculate ratios, like the debt-to-income ratio. If a borrower has a lot of other debt compared to their income, then they are considered a higher risk for lenders.
- Individual income â Personal finances are evaluated by lenders to determine whether or not the borrower can repay the debt. In order to determine an individualâs income, lenders may request copies of individual income tax returns and bank statements.
- Collateral â Collateral for a personal loan is required when borrowers are approved for a secured personal loan. The collateral may be a personal asset, like a home or car. If a borrower cannot get approved for unsecured personal loans or lines of credit with acceptable loan terms, a secured loan may still be an option.
The pros and cons of using a personal loan to start a business
Before starting the application process for a personal loan, youâll want to decide it is the best source of financing for your new business loan. Just like any other financing decision, itâs important to review the pros and cons before you commit yourself to a debt obligation.
Advantages of personal loans for small business owners
While personal loans are not the first choice for most business owners, there are some advantages to using a personal loan to cover startup business costs.
- Fast capital â Personal loans are a good option for startup entrepreneurs to get the capital they need to get their business off the ground. The proceeds from personal loans can be used for hiring employees, launching marketing campaigns, purchasing inventory and equipment, and the legal costs associated with starting a business. Personal loans can be approved in as little as one to three business days with the right lender and funds can be deposited directly into the borrowerâs bank account.
- Build credit historyÂ â Using personal loans for a new business is a viable option for entrepreneurs that do not have strong personal and business credit history. However, personal loans are also a great way for new business owners and those with damaged credit histories to build better credit (assuming you make all your payments on time!). Improving the small business ownerâs creditworthiness will increase the number of business financing options available in the future.
- Flexible use of funds â There are rarely restrictions on what the proceeds from a personal loan can be used for. Personal loan applications do ask borrowers what they intend to use the funds for, but there are not many restricted categories. Personal loans can be used to cover personal purchases and expenses, to refinance other debt, or to cover business startup costs.
Disadvantages of personal loans for small business owners
While there are some clear pros to using a personal loan for a new business, there are also some disadvantages to this type of financing option.
- Financing costs â The overall financing costs of a personal loan are typically higher than other financing options for small business owners. The increased costs come from higher interest rates or annual percentage rates (APR), higher loan origination fees, and increased late fees and prepayment penalties.
- Personal liability â Perhaps the biggest con of using a personal loan to finance a business is the personal liability for the entrepreneur. If your new business venture fails, you will still be responsible for repaying the loan. The personal loan will also be considered when determining your personal creditworthiness which may have a negative impact on personal financing options, like purchasing a family home or getting approved for a car loan.
- Repayment terms â Personal loans are typically approved for lower loan amounts than business financing. They also have higher interest rates, higher loan origination fees, and shorter terms than other business financing options. Overall, the amount approved for the average personal loan will be lower than other business lending options and have a higher financing cost for the borrower.
Other financing options for new businesses
Now that weâve examined some of the pros and cons of using personal loans for business use, we can explore alternative options for financing a business. It is a good idea to consider the advantages and disadvantages of all business financing options before applying for a personal loan.
Crowdfunding for business needs is a financing option that has been gaining in popularity throughout the last decade due to websites like GoFundMe and Kickstarter. Crowdfunding is the process of collecting a number of small investments or donations from multiple people.Â There are different methods of crowdfunding that determine if the funds collected are considered donations or if a reward or portion of the companyâs equity is exchanged for the investment.
If the startup business funds you are seeking are for the purpose of financing a franchised business, there may be franchisor financing programs you can participate in. Many companies, like UPS and Goldâs Gym, provide financial assistance programs to their franchisees. The programs are funded by the franchisor or a partnering lending company and are intended to provide affordable franchise financing to interested franchisees.
Small business loans
The most common type of financing used by entrepreneurs is small business lending options. There are several different types of business loans that small business owners can use to cover startup costs, purchase commercial real estate, or cover operating expenses during the first year. One of the best advantages of business financing is that the interest paid on those loans is a tax-deductible expense for the business.
The process to get approved for a small business loan works similar to personal lending, except the focus is on the business.Â Business lenders will review the following when considering your business loan application:
- Financial statements â Lenders will look at the annual revenue and net income of the business using one or two years of income statements. The value of the businessâs assets and liabilities are also evaluated based on the amounts listed on the balance sheets.
- Income tax returns â Some lenders and types of loans require that the business has been operating for two years. The length of time in business and the net income generated at the business can be evaluated using federal income tax returns.
- Credit history â The business credit history and credit score of the business will help the lender determine the businessâs ability to repay the loan and the interest rates and down payment required. If you donât know your business credit score, you can get a copy of your business credit report here.
- Business plan â Lenders often request a copy of the business plan when evaluating business loan eligibility. The business plan will share details about how the business will be funded, the projected revenues, industry competition, and marketing strategies.
Types of small business loans
If you are considering a loan to cover business expenses, starting with a small business loan application may be the right move for your financial situation. Working with a local bank or alternative lender is a good way to get started with a traditional business loan application. Alternative lenders, like Biz2Credit, are often the best place to start because they connect clients to multiple loan offers and work with a larger variety of borrower approval requirements.
Some examples of small business loans that are right for entrepreneurs include the following types of financing options:
A term loan is a traditional type of loan where the borrower receives an approved amount of funding upfront and repays the loan according to the repayment terms. Business term loans can be secured or unsecured and may require a personal guarantee. Term loans can be approved for amounts up to $500,000 and require moderate creditworthiness of the business owner. The application process for a term loan can be done in person at a bank or online with online lenders, like Biz2Credit.
SBA loans are a type of business financing where a portion of the funds is backed by the U.S. Small Business Administration. There are several loan programs available through the SBA loan guarantee program which include the SBA 7(a) and Microloan programs. SBA loans offer financing options with lower interest rates, smaller down payments, and longer repayment terms for business owners that can meet the eligibility requirements.
Business line of credit
A business line of credit is a type of revolving credit, like business credit cards, where the borrower is approved for a maximum credit limit and can withdraw cash whenever cash flow is low. The monthly payments for lines of credit include interest, which is calculated on the total amount of funds withdrawn.
Key Takeaway: Is it better to use a personal loan or a business loan to start a business?
Taking out a personal business loan to start a business is not a bad move for borrowers that do not have excellent credit and have struggled to qualify for a business loan. However, using personal loan funds for business purposes should be a short-term solution. Small business loans offer longer repayment terms, higher loan amounts, lower interest rates, and less liability for the borrower.
If youâre ready to turn your business idea into a reality, reach out to Biz2Credit today to learn about startup financing. After all, they are the financial experts that were able to help Ray Vasquez get the funding he needed to open his dream restaurant, Johnny Rockets Sports Lounge.
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