Businesses rely on cash flow to expand and maintain operations. Sometimes, the cash flow doesn’t come quickly enough. Seasonal businesses need additional funds during slower months, and every business owner could use an extra funding source. Luckily, business owners have many ways to secure the funding they need. Many aspiring business owners and entrepreneurs leverage personal loans and small business loans to secure their startup funding, but which one makes the most sense for your new venture?
We will conduct a deep analysis of the two popular financing options and discuss a unique platform to help you find the perfect loan to finance your business.
What is a Personal Loan?
As the name indicates, a personal loan is a debt product that can be used however you see fit. The lender will likely inquire about your intended use but typically won’t follow up or monitor how you spend the funds.
So, you can pay off high-interest debt, fund home renovations, take a trip you’ve been dreaming of, make a big-ticket purchase, or do anything else with that loan. But as a new business owner, it may be more appealing to use the funds for startup costs for a few reasons.
The qualification criteria for personal loans are less stringent than what you’ll find with a small business loan. Most lenders review your credit score, income, and current debt obligations to determine if you qualify and how much funding to offer you. You’ll have to submit these details to most lenders, but small business loans require additional details. For example, lenders may want to see detailed projections regarding your new business venture and your company’s annual revenue.
Furthermore, personal loans come with a fixed interest rate determined by your credit rating – the higher your credit score, the more competitive the rate. And the monthly payments are fixed for the life of the loan.
Keep in mind that some lenders charge an origination fee. You’ll have to pay this fee to receive the loan proceeds. You also want to consider the repayment term for personal loans. Most lenders will give you three and five years to pay off the entire balance, which means the payments could be a bit steep as you work on your startup.
You’ll have to assess your monthly budget to see how much you can afford. Extending your loan’s duration will reduce your monthly payments since you spread the loan amount across more intervals. Opting for a 3-year loan instead of a 5-year loan will increase your monthly payments but get you out of debt sooner.
What is a Small Business Loan?
Small business loans are another popular funding source for new small business owners. Traditional banks, financial institutions, credit unions, online lenders, and the U.S. Small Business Administration (SBA) make them available to millions of business owners.
You can choose from an assortment of small business loan options, including:
- Working capital loans: These are installment loans that operate like personal loans. You’ll get a lump sum payment and repay in monthly installments over time. But the funds must be used to cover business expenses, like inventory, marketing, payroll, and rent for your workspace. Working capital loans are ideal for short-term expenses. Business owners rarely take out these loans for long-term investments.
- Business line of credit: You’ll get access to a pool of funds that you can withdraw from as often as you need during what’s referred to as the draw period. You can also repay a fraction or all of what you owe during the draw period. You’ll be subject to interest-only payments on the amount you borrow. When the draw period ends, the lender converts the remaining balance into a loan payable in monthly installments (for principal and interest) over a set period. Most people use business credit cards to get their credit line, but you can get business credit that isn’t tied to a card. Since business credit is revolving, you don’t have to continuously apply for additional funds. When you repay the line of credit, you can borrow against it again if you need additional capital.
- Term business loans: These loans are also installment loans, but business owners usually take out these loans for long-term investments. You will have to make monthly payments towards the principal and pay interest based on your credit score and other factors. Some business lenders let business owners borrow $1million, $2 million or more through small business term loans, an amount you will never get from a lender offering personal loans.
While small business loans are plentiful, they have more requirements than personal loans. Small business lenders look at the financial health of your company, not just your personal finances. This can extend the amount of time it takes to receive funding since you’ll have to assemble more paperwork. You’ll also have to present a business plan to the lender so they know how the loan can grow your business. Some lenders will also look at your business credit score alongside your personal credit score. While small business loan preparation takes longer, these types of loans usually provide more capital to fund your startup. Some business owners resort to small business loans after discovering personal loans do not provide sufficient startup funds.
When Does It Make Sense to Get a Loan for Your Business?
A business loan makes sense when you have a viable business idea that generates revenue. Throwing money at an unproven business model can lead to more mistakes and accumulating debt. You should only make investments once you feel confident in your business and generate enough cash flow to afford the monthly loan payments. Loans are useful for making investments and providing additional capital. However, they can become logistical nightmares if you don’t have the plan to repay them consistently.
Lending requirements can also impact when you feel ready to qualify for a loan. Most small business lenders have revenue requirements for their financial products. If you don’t have those revenue numbers, you can get started with a personal loan which has fewer requirements. However, you’ll probably be out of luck if you need to borrow more than $100,000 for your personal loan, assuming your lender makes that offer. Most lenders won’t make that type of offer, and some businesses would need additional financing even after receiving $100,000.
Can Personal Loans be Used for Business Purposes?
Lenders don’t restrict the usage of funds, despite inquiring about the intended use during the application process. No one will stop you from using your personal loan proceeds for any purchase, including for business purposes. A personal business loan can help with short-term needs and generate initial momentum. However, most of these loans don’t have enough principal for long-term business investments. For example, you wouldn’t use a personal loan to purchase a commercial real estate property or a very expensive piece of equipment.
Should You Get a Personal Loan or a Business Loan?
Whether to take a personal loan to start a business or not depends on your financial situation and how much you want to borrow. If you have good or excellent credit and a steady source of income, personal loans usually aren’t hard to get. Personal loans have fewer obstacles since you can use them for any purpose. Most borrowers receive their loan proceeds a week after submitting their applications, but results differ across lenders. Some small business owners wait up to a month for their personal loans, but that’s not as long as loans from the U.S. Small Business Administration. Some SBA-backed loans have 3-month long processes, which can feel excessive if you need capital right away.
If you opt for the personal loan route, it’s an easier application process. You won’t have to answer any questions about your new business venture from the personal loan provider. Meanwhile, small business lenders will ask about your annual revenue, business plan, and other details. These extra hurdles can add time to the preparation process and affect your startup’s chances of receiving funding.
While you skip these obstacles with a personal loan, these financial products have significant drawbacks. The amount you’re eligible for may not be enough to cover your projected startup costs. You may have to borrow money from friends and look at other financing strategies to make up the difference. Personal loans can also have higher interest rates since they are unsecured loans that don’t require collateral. You could also get funding through your credit card, but high-interest rates make this an unattractive option. Finally, for most business owners, a personal loan isn’t enough to cross the finish line.
By contrast, a small business loan could get you an ample amount of working capital. But the lender may request collateral along with supporting documents to substantiate your funding request. Personal loans do not require collateral, making them less risky than their counterparts. Still, a business loan is worth a shot, particularly if you need $100,000 or more to fund your new venture. A 2022 TransUnion credit industry report, revealed that most personal loans don’t exceed $10,000, making them too small for many business owners.
Small business loans also offer competitive rates, and you could qualify for an extended loan term, which makes the monthly payments more affordable. While collateral on small business loans increases your risk, having collateral on your loan also lowers the interest rate. You don’t have to worry about losing the collateral if you make the monthly payments, and personal loans don’t offer this option. Lower costs will alleviate the added stress of turning a significant profit out of the gate. You will also have more room in your budget for other investments in your company.
How to Get Lower Interest Rates
Lenders make money from loans through administration fees and interest rates. You can’t change administration fees, such as loan origination, but you have more control over interest rates. Some extra legwork before submitting your loan application can go a long way in reducing your monthly budget.
Lenders assess applicants based on their financial health and ability to handle debt. These criteria apply to personal loans and business loans. In addition, a lower interest rate can make a loan more enticing and encourage you to borrow more capital.
Monitoring and improving your credit score is a great place to start for lower interest rates. Checking your credit report for errors can yield immediate gains. You can inform one of the major credit bureaus about the error, have them change it, and then it will get reflected on the other credit reports. You can get a free credit report each year from each of the three major credit bureaus (Experian, Equifax, and TransUnion).
Reviewing your credit report is a great starting point, but you’ll have long-term success by focusing on payment history and credit utilization. These credit scoring categories make up 65% of your score. On-time payments will improve your credit history, and keeping your balances low will strengthen your credit utilization ratio. Borrowers should aim for credit utilization ratios below 30% to raise their scores. Business lenders will also look at your business credit score to determine your interest rate.
Minimizing your debt-to-income ratio will also help you get a better interest rate. For example, if you pay $2,000/mo in debt and earn $5,000 per month, you will have a 40% debt-to-income ratio. A lower debt-to-income ratio translates into lower interest rates and higher loan amounts. You can improve this ratio by paying down debt, making more money, or extending the duration of your loans. Several factors go into determining your interest rate, but staying focused on these essentials helps borrowers who are applying for personal loans and business loans.
These strategies will also help you qualify for higher loan amounts. Lenders use these same details to determine your maximum loan amount. Improving your credit score and the debt-to-income ratio increases your possibilities.
Can You Use a Personal Loan to Start a Business?
If you want to use a personal loan to start a business, you’re in luck. You can use the proceeds to fund your business, but most business owners need more than what a personal loan provides. Personal loans can get you past the starting line, but business loans can make your company feel more sustainable.
Financial institutions will ask for your personal information during the loan application process. They offer favorable terms to borrowers with good credit, so raising your score a bit before applying for the loan can make a difference. Since it’s a personal loan, you only need a personal credit score. It’s okay not to have a business credit score if you only need a personal loan.
Depending on your business, a personal loan may be all that you need. Personal loans work well if you only need a few thousand dollars and a quick path to funds. However, you should explore business funding opportunities and weigh your finance options before resorting to a personal loan to cover startup costs. Approach your lender with a number in mind. You’ll know if the loan is enough or if you will need additional financing. If a gap exists, you should consider a business loan to fill in the difference.
