What is a Personal Loan?Personal loans are loans you can take out for a variety of purposes, including starting a business. Speaking of getting loans for businesses, personal loans are often easier to get than business loans, making them excellent tools for brand new entrepreneurs without enough capital on hand. However, they may not be for everyone. In fact, a survey found that barely 1% of personal loan borrowers even use their loan to start a business. This signals that personal loans may not be the best financial tool for every entrepreneur out there. With that in mind, make sure you consider the following before getting a personal loan for your business.
Things to Consider Before Getting a Personal Loan For Your Business
1. The Fine PrintA fair number of personal lenders are fine with you using your personal loan on anything, as long as it’s legal, of course. However, some personal lenders may be a bit picky. You might be restricted from using it for reasons they deem risky, such as starting a business. After all, if your business fails, they might not get their money back. So check with each lender you’re looking at borrowing from to make sure you’re allowed to use your loan for business purposes before signing the contract.
2. What You Need the Money ForThis might be obvious, but you should know exactly what you need the money for. That way, you can figure out exactly how much you need to take out. You don’t want to saddle yourself with extra debt. Sure, if you overestimate, you might have some extra capital for other things. But without a defined purpose for every dollar, it’s easy to take out more than you need and end up throwing away money on interest. You’ll pay a higher interest rate on a higher principal balance, which can add up fast. Not to mention burdening yourself with a higher monthly payment in general. This plays into the next consideration you should make, your debt-to-income ratio.
3. Debt-to-Income RatioYour debt-to-income ratio (DTI) is a comparison of your monthly debt payments relative to your gross monthly income (income before taxes). For example, if you have a $1,000 mortgage and $400 car payment, and you make $4,000 every month, your DTI ratio is 0.35, or 35%. Most personal lenders won’t look at your DTI. However, it’s important to know your DTI for personal purposes. If your DTI is already high (about 40% and above), adding another loan payment can stretch your budget thin. Even if your business is highly profitable early on, debt could eat up much of your earnings — preventing you from enjoying the spoils of your success. So pay down some debts first if your DTI is already high. See if you can target some smaller “bad” debts, like credit cards and other personal loans, and get rid of those. Use accounting software like Quickbooks to quickly find these debts and identify the best candidate for a fast repayment.
4. Business PartnersAre you co-founding this business with other people? If you take out a loan, you may think you’re only responsible for your even share of the debt. As in, if the loan is $20,000 and you have three other partners, that’s $5,000 per person. However, things may not work exactly like that. If your loan is “jointly and separately liable,” that means everyone is collectively and individually responsible for the loan. Unfortunately, you could be liable for the full balance of these kinds of loans if your business partner(s) become unable to afford it.
5. Credit CardsPerhaps you have the capital to start the business itself, but there are also some smaller, short-term purchases to make (such as some necessary office supplies). A personal loan would be highly cost-ineffective here. Instead, consider getting a business credit card. Business credit cards let you access funds on demand and pay them off when you can. You can avoid interest entirely by paying off your balance in full each month. Plus, credit cards let you earn cash back on purchases. By using a credit card to help cover some startup costs, you essentially score a small delayed discount on everything.
6. Exit StrategyHere’s a stat that might scare you or (hopefully) motivate you to work hard: about 20% of businesses fail within the first year — and half within the first five years. Obviously, you aren’t hoping to fail. However, you should have a plan to pivot to something else in case your idea fails. By doing so, you can continue putting your personal loan to use without getting stuck in more debt. If you don’t have an exit strategy or a way to pivot, you’ll be stuck with a personal loan payment yet get no benefit from the debt.
Do Your Due Diligence FirstPersonal loans can be excellent tools for some budding entrepreneurs, but they certainly aren’t for everybody. Sure, they can be easier to get than business loans, but business lenders have strict requirements for a reason. They want to be absolutely sure you’ll succeed. This isn’t to say that your business won’t succeed. You just have to make sure your business plan is feasible, and that you can take on the personal loan debt without risking your overall financial health. If you don’t have much debt right now, and your financial ducks are in a row (emergency fund, retirement savings, etc.), a personal loan might work for you. Otherwise, it could be a better idea to continue saving your own money before launching your business.