The quick answer is yes. Personal loans can and are often used to fund small businesses, but there are some important caveats to consider. While some lenders don’t care what you use the money for, others will deny loan applications from entrepreneurs looking for startup capital. Read SuperMoney’s expert and consumer reviews to find the best option for your business.
If you’ve been laid off and are having a hard time finding another job, becoming an entrepreneur may seem more appealing than continuing to send out resumes with no results. Or perhaps you have a longtime dream of being your own boss. Either way, one of the biggest obstacles you will face is finding the working capital you need to start your business. This article analyzes some of the financing options available to small startup companies.
Family and friends can be a good place to start if you’re looking for people who will believe and invest in your new business idea. Nearly 40% of new businesses are financed in this way. However, if you need more capital than you can raise by drawing from your personal resources or those closest to you, you need a commercial loan. The problem is that most business loan providers are hesitant to extend business loans to startups. A personal loan could provide the capital you need to get your business up and running so that you can eventually qualify for commercial loans.
Why the difference between a business loan and a personal loan? It’s a matter of risk. Usually, business loans are not personally guaranteed by the owner of the business. If the company goes under, its assets are liquidated to pay off creditors, but the personal assets of the business owners are not at risk. Not so with personal loans. It’s the reason Donald Trump has been able to file for bankruptcy four times without his personal net worth taking a hit.
Alternative Business Loans
Until recently, small businesses did not have many alternatives to traditional bank loans. Businesses that needed capital fast often had to resort to costly merchant cash advances. Traditional merchant cash advances provide business with a lump sum and then skim a share of their daily credit sales. This provides a flexible payment system, but interest rates can be high: 120% APR and higher.
Bank or Credit Union Loans
If you have an established financial relationship with a bank or credit union, begin your search for a personal loan there. Traditional lenders usually provide the best rates and terms, but their application process can be slow, and they have stringent eligibility requirements. Customers with few or no overdrafts who have successfully repaid an auto or mortgage loan in the past have a much better chance of being approved for a personal loan with a bank or credit union.
Home Equity or Other Collateral-Backed Loans
Before the housing market crash, many homeowners viewed their houses as cash cows. The overheated market allowed many homeowners to build significant equity within a few years of purchasing their homes, enabling them to finance expensive kitchen and bath rehabs, lavish vacations or big weddings with home equity loans. Today, home equity loans are less common, but they haven’t gone away. If your credit is less than stellar, a home equity loan or another type of personal loan backed by collateral may be your best option for financing your entrepreneurial venture. Just remember you could lose your home or property if you default on your home equity loan.
Peer-to-peer loans are another financing option for small business. Their interest rates are competitive, as low as 6%, and they have flexible repayment terms (up to 60 months). Peer-to-peer lenders match lenders directly with borrowers. They usually operate entirely online, which allows them to run with a lower overhead and provide lower interest rates. P2P lenders do require would-be borrowers to expose a great deal of their personal information along with their financial profiles when applying for a loan and the approval process can also be slow. Borrowers can wait up to two weeks for investors to fund their loan. The most successful P2P lenders, such as LendingClub, have joined forces with large institutional investors, which can cut the funding time to a week or less.
Personal Loans Vs Credit Cards
Many would-be entrepreneurs eagerly eye their credit cards as sources of easy cash. The trade-off for their convenience is that fees and interest rates on cash advances get expensive fast. A better strategy for using your credit cards as capital is to use them as interest-free short-term loans. Put business purchases, such as office supplies, computers or even inventory, on your card and pay it off before the grace period ends. By using your credit cards to purchase goods and services, you avoid the fees associated with cash advances. If you chose your business credit card wisely, you would also be earning valuable points you can put toward business travel or statement credits.
Raiding Your 401(k) or IRA
If you’re having trouble financing your small business or entrepreneurial venture, your retirement funds can also be a source of funding. Many retirement funds allow you to borrow up to $50,000 without penalty if you have a large enough balance and repay the funds within a certain period.
If you don’t repay the funds, you face stiff early withdrawal penalties. Even if you do return the funds, you forfeit potential earnings from your money that you may not be able to make up. For these reasons, it is best to avoid tapping into your retirement funds if you can avoid it. Roth retirement accounts have less financial penalties and restrictions than traditional IRAs or 401(k)s because they are made up of after-tax contributions.
Better Credit Means Better Loan Rates
If you’ve decided to go the personal loan route to fund your small business, do everything possible to clean up your credit history and raise your credit score first. Borrowers with low credit scores can still obtain personal loans for their business, but they will have to contend with higher interest rates and less favorable terms. Borrowers with good credit — 720 and above — can usually obtain personal loans with better terms and lower rates.
Loans of Last Resort
Conspicuously absent from this list of potential sources of funding are pawn shops and payday loans. Aunt Mildred’s diamond tiara may very well be worth enough to generate the funds you need from a pawn shop. But in the unfortunate event that you are unable to repay the loan, Aunt Mildred’s tiara will be lost forever. Likewise, payday loans are usually a bad bet. Their triple-digit interest rates and short repayment periods make them a financial trap from which it can take months, if not years, to escape. If it feels like pawn shops and payday loans are your last hope for funding, you may consider taking on a second job or selling unwanted possessions instead.
Not sure which loan type or business loan providers is best for your new business? SuperMoney’s expert and customer reviews on business loans are a valuable resource you can use for free.