When starting a business, should you use a Business Loan or a Personal Loan ? It’s important to consider your financing options carefully. Both business and personal loans can be viable sources of funding. But, there are several factors to consider when deciding which one to choose. Here are some key points to help you make an informed decision.
What is a Business Loan?
It refers to a financial arrangement between a lender and a business entity. A business loan gives businesses a specified amount of funds to back its operations or other financial needs.
In a business loan, the borrower agrees to repay the loan amount with interest over a predetermined period. Usually, business loans cover expenses, such as buying equipment, employee salaries, rent, managing cash flow, hiring employees, or expanding the business in other cities.
How do Business Loans Work?
Business loans offer financing to business owners in the form of a credit line or a lump sum. Your business promises to repay the funds it borrows over time with interest and fees in exchange for this funding. Until the loan is entirely paid, your lender may need daily, weekly, or monthly repayments, depending on the type of business loan you took.
Moreover, loans for businesses can either be secured or unsecured. Secured loans need collateral. Collateral includes real estate, cash, equipment, or assets. The lender can seize them if you default on the business loan.
Conversely, collateral is not necessary for unsecured loans. Instead, you need to sign a personal guarantee. In the personal guarantee, you commit to accept responsibility if the business fails to pay its loan as agreed.
Types of Small Business Loans
1. SBA Loans
SBA loans (Small Business Administration loans) are among the best options for small business financing. The government partially guarantees these loans. The SBA collaborates with credit unions, banks, and other loan lenders to offer small business owners financial assistance.
Lenders find giving loans to small businesses risky. That’s why they’re usually reluctant. Between the borrower and the lender, the SBA serves as a guarantor. Lenders give the SBA their terms and conditions, interest rate caps, and other requirements for approval.
The SBA offers a variety of options. You can select any that would be appropriate for your business needs. Your business needs may be paying off debts or mortgages, buying inventory, or growing your business.
Flexibility, simple payback terms, and cheaper interest rates than term loans you get directly through a bank are just a few advantages of financing with SBA loans. SBA loans aren’t appropriate for everyone. They involve a lengthy application procedure, a personal credit check, and collateral restrictions.
2. Traditional/Conventional or Term Loans
These are one of the most common types of small business loans. Usually, banks and other financial institutions offer term loans. They provide a lump sum of money to the borrower. The lump sum is repaid over a fixed term with regular installment payments.
Usually, traditional loans have fixed interest rates and need collateral or a personal guarantee to secure the loan. The repayment term ranges from a few months to several years. It depends on the borrower’s creditworthiness and the loan amount. These loans are suitable for established businesses with a stable cash flow and a solid credit history.
3. Equipment Financing Loan
It’s a popular type of small business loan that finances acquiring or upgrading business equipment. Equipment financing loans enable businesses to buy machinery, vehicles, or other essential equipment for their smooth operations.
Usually, the loan amount depends on the value of the equipment financed. Besides, it can range from a few thousand dollars to millions, depending on the size and needs of your business. The equipment itself serves as collateral. That makes it a secured loan option.
This type of loan assists small businesses to improve productivity, manage cash flow, and stay competitive by accessing the necessary tools and assets for business growth.
4. Specialty Loans
Businesses that meet the set standards can apply for specialty loans. It depends on the owner’s age, race, gender, or the business sector. That includes the nonprofit, agricultural, or medical industries.
Not all businesses are eligible for specialty loans. The specialty loans can only benefit a business enterprise that meets the eligibility criteria. For instance, the SBA provides several loans for minority-owned small business enterprises.
5. Merchant Cash Advances
With Merchant Cash Advances (MCA), businesses can receive a lump sum of cash through a lender in exchange for a percentage of their future sales. Unlike ordinary business loans, you’ll repay the Merchant Cash Advance using regular business sales.
It’s a fantastic lending option for small firms that have a high volume of sales and want quick access to cash.
Pros and Cons of a Business Loan
- You will overcome cash flow issues
- It can be less costly than other forms of borrowing
- There’s flexible use of the funding
- You don’t have to dilute your equity
- You’ll expedite your business’s growth
- You can lose assets if you default on loan repayments
- It has an extensive application procedure
- You may not get the funds for a while
- There’s no flexibility when it comes to loan repayments
- You will need a strong credit profile
What Is a Personal Loan?
It’s a type of loan that allows you to borrow a specific amount of money from a financial institution or lender for various purposes. Usually, it’s for personal expenses, such as consolidating debt, funding home renovations, planning a dream wedding, or covering unexpected expenses.
Personal loans are repaid over a fixed period with regular installments, including interest charges.
How do Personal Loans Work?
Once you’ve been given the go-ahead for a personal loan, the funds are transferred into your checking account. If you’re applying for a loan to repay your current debt, you might ask your lender to pay your invoices.
For example, if you’re eligible for a loan, you can choose to have your money routed to your creditors instantly. This way, it prevents you from using the money for other purposes.
No matter how you receive your funds, be ready to begin repaying within 30 days. If your loan has a fixed rate, your monthly payments will remain the same until you repay. Your interest rate may change from month to month if you have a variable-rate loan. It can affect how much you owe.
The credit line closes when you repay your loan. You won’t access it anymore. Besides what we’ve talked about, you can use a personal loan to cover other expenses, such as:
- Debt consolidation
- Moving expenses
- Funeral costs
- Medical bills
- Vacation costs
Types of Personal Loans
1. Secured Personal Loans
This type of loan needs collateral to secure it. Collateral can be assets, such as a house, boat, car, real estate, or savings or stocks account.
Since there’s collateral involved, these loans usually offer lower interest rates than unsecured loans. But, if the borrower fails to repay the loan, the lender seizes the collateral to recover their funds. You can get a secured personal loan from a credit union, a bank, or an online lender.
2. Unsecured Personal Loans
An unsecured personal loan doesn’t ask for any asset as collateral. And, because your loan agreement stipulates a specified period for repayment and a predetermined monthly payment, unsecured loans are sometimes referred to as term or installment loans.
Lenders determine your ability to repay the loan, depending on your creditworthiness and financial situation. That’s because there’s no collateral. You might pay extra every month because unsecured loans often have higher interest rates than secured loans.
3. Debt Consolidation Loans
These are loans that help you manage your existing debts effectively. Debt Consolidation loans enable borrowers to combine multiple debts, such as credit card balances or other loans, into a single loan with a lower interest rate and fixed monthly payments.
Borrowers can simplify their finances by consolidating their debts. It also reduces their overall interest costs, making it easier to pay off debts over time.
4. Co-Signed Loans
This type of personal loan involves a co-signer who assumes responsibility for the loan if the borrower fails to make payments. Usually, borrowers with limited credit history or poor credit scores use this loan type. If you have a co-signer with a strong credit profile, that increases your chances of loan approval.
Co-signed loans offer more favorable interest rates and terms than other personal loans. That’s because the co-signer’s creditworthiness provides additional security for the lender.
5. Personal Line of Credit
A personal line of credit (PLOC) is separate from the other types of personal loans. You can use a debit card or bank cheque to access the credit limit on a PLOC.
You can even ask your lender to move your funds to another account electronically. Many are perpetual. But, some lenders set specific draw and repayment times.
A personal line of credit is a form of revolving, reusable debt. Your lender sends you a monthly statement that details how much money you owe. It depends on your expenditure and interest. You can borrow it once more after paying it back.
6. Fixed-Rate Loans
This loan offers stability and predictability. With this loan, the interest rate remains fixed throughout the loan term. That means your monthly repayments are constant. Fixed-rate loans are beneficial for budgeting purposes. They allow you to plan your finances confidently, knowing your payments won’t fluctuate.
Fixed-rate loans provide a consistent repayment structure whether you need funds for home improvements, debt consolidation, or other personal expenses.
7. Adjustable-Rate Loans
It’s a common type of personal loan that gives borrowers flexibility in interest rates. The interest rate of this loan isn’t fixed. Instead, it adjusts periodically, depending on prevailing market conditions.
Usually, the initial rate is lower than that of fixed-rate loans. That makes it an attractive option for those seeking lower monthly payments. But, the interest rate can rise or fall over time, depending on market fluctuations. It also results in higher repayments in the future.
Adjustable-Rate Loans are ideal for borrowers who expect changes in their financial situation or plan to pay off the loan fast to reduce the impact of rate adjustments.
Pros and Cons of a Personal Loan
- It has fast funding times
- You don’t require collateral
- You’ll receive one lump sum
- There’s versatility and flexibility in a personal loan
- It has lower interest rates
- It’s easier to manage
- There are extended loan terms
- There are more eligibility requirements
- Its interest rates can be higher than other loan alternatives:
- There’s an additional monthly payment
- There are higher payments than credit cards
- Potential credit damage
- There’s an increased debt load
Should you Use a Business Loan or Personal Loan to start a Business?
When considering whether to take a business or personal loan to start a business, weigh the pros and cons. We discussed the pros and cons of each earlier.
Besides the pros and cons of each, there are several differences between the two loan types. Let’s get right into it!
- Liability: It’s a primary difference between a business and a personal loan. For a business loan, the liability rests with the business itself. That means the lender won’t come after your assets if the business fails to repay the loan.
On the flip side, a personal loan makes you personally liable for repayment. So, your assets may be at risk if you default on the loan.
- Creditworthiness: When determining loan eligibility and interest rates, lenders evaluate your creditworthiness. You can secure a business loan at a favorable interest rate if your business has a strong credit history and an excellent financial track record.
But, if you have a new business or it doesn’t have an established credit history, lenders may consider your creditworthiness when assessing a business loan application. In these cases, a personal loan might be easier to apply for if you have an excellent personal credit score.
- Loan Amount and Terms: Generally, business loans offer higher loan amounts and longer repayment terms than personal loans. The reason is that businesses often need more substantial funding and more time to generate profits.
So, a business loan will be suitable if your business needs a large infusion of capital or a longer repayment period.
On the other hand, personal loans are usually smaller and have shorter repayment terms. That makes them more suitable for personal expenses or smaller-scale business undertakings.
- Interest Rates and Fees: They can vary significantly. It depends on the lender and the type of loan. Generally, business loans may have lower interest rates than personal loans, particularly if you have a solid business credit profile.
But, if you have excellent personal credit, you can secure a competitive interest rate on a personal loan. Compare the rates, terms, and associated fees for both loan types. This way, you’ll determine which option is more cost-effective for your situation.
- Legal and Tax Implications: Structuring your business financing correctly may have legal and tax implications. There may be specific regulations or tax advantages associated with business loans. It depends on your jurisdiction and business structure.
Consult with an accountant or financial advisor to understand the implications. Then, make an informed decision.
When a Business Loan can make Sense
Small company loans can give you the funds you need to handle various obligations. A business loan can make sense if you’re:
- Expanding operations
- Purchasing inventory
- Replacing or upgrading equipment
- Bolstering cash flow
- Hiring and training new staff
You have various business loan options to pick from. They are all intended to help you reach your financial objectives.
When a Personal Loan for Business can make Sense
A personal loan is issued directly to the borrower. You can use it for either personal or professional purposes. A personal loan is suitable if you’re a business owner who lacks the credit history necessary to obtain a business loan.
You might also choose an unsecured personal loan if you don’t have any assets that can be used to secure a company loan.
Inquire with the lender about using the personal loan for company needs. It’s better to be upfront about your plans to avoid breaking any loan restrictions. If you use a loan for an improper reason, the lender may require you to repay the entire amount plus interest right away.
Alternative Forms of Business Funding
- Crowdfunding: It involves raising capital from many individuals, usually via online platforms. Entrepreneurs pitch their business ideas or projects to a broad audience. Then, the audience contributes varying amounts of money.
- Grants: It’s a popular business funding that doesn’t need repayment. Government agencies, foundations, or organizations provide these funds to support specific projects or initiatives.
- Peer-to-peer lending: In this funding, individuals or investors directly lend money to businesses through online platforms. It bypasses traditional financial institutions. Besides, it allows businesses to secure loans, depending on their creditworthiness and the terms negotiated with lenders. It makes it a more accessible and flexible financing option.
- Pitch competitions: In pitch competitions, entrepreneurs present their ideas to a panel of investors and compete for financial support and mentorship opportunities.
- Venture capital and angel investment: This funding involves investors providing capital in exchange for equity or ownership stakes in early-stage or high-growth companies.
- Fintech: This source of business funding uses technology and digital platforms to connect borrowers and lenders. It also provides streamlined access to capital and financial services. Usually, it has a faster approval process.
Selecting between a business and a personal loan depends on various factors. These factors include liability, loan amount, creditworthiness, interest rates, terms, fees, and legal/tax considerations.
Evaluate your business’s needs and financial situation to determine the most suitable option. Consult with financial professionals. They’ll provide valuable insights tailored to your circumstances.