Should You Use a Personal Loan to Start or Grow Your Small Business?

If you're starting a new business and need finance to do so, you're almost certain to be personally liable for that debt, whether it's a personal loan, small business credit card, or some other form of credit. True, close friends and family members may be prepared to take a chance on you, but professional lenders pretty much invariably expect new entrepreneurs -- even those with dazzlingly bright ideas and fantastically clever business plans -- to put their personal assets and credit score on the line. Only those with a proven record of successful business startups are likely to be exceptions.

Smart Startup Borrowing

Superficially, borrowing from family and friends to start a new business can be a good idea. You stand a better chance of raising the money because they know and trust you, and you may well pay significantly lower interest rates compared with rates from bank and card loans. But of course, you may be putting your relationships with some of the most important people in your life on the line. How would they feel about you if your venture went under, and they lost their entire investments? You probably will think it a bad idea to borrow more from any one person than he or she could comfortably afford to lose.

You may sleep easier at night if you raise funds from professional lenders, such as banks, credit unions and credit card companies. With them, you have four main choices :

  1. Personal loan: You borrow a fixed amount, and make equal monthly payments until you zero your balance on a pre-agreed date. Don't forget to consider peer-to-peer lenders for these, as well as more traditional sources.
  2. Personal line of credit: You're given a credit limit, and can borrow as little or as much up to that as you need. Each month, you only pay interest and make payments on what you owe. These provide more flexibility than ordinary personal loans, and that can be valuable for a start up.
  3. Business credit cards: These are similar to personal lines of credit in many respects, but you may have to pay higher rates on what you borrow. On the plus side, you should get valuable rewards. Best, if possible, to use these as convenient ways to pay and sources of rewards -- and zero balances every month.
  4. Home equity product: You should get a lower rate on one of these, but that's because you're putting up your home as collateral. If you fall behind with payments, you could face foreclosure. In other respects, home equity loans are a lot like personal loans, while home equity lines of credit (HELOCs) are a lot like personal lines of credit.

Getting Off the Hook

The trouble with all four of those options is that the debt is almost certain to be yours personally. So a late or missed payment is going to hurt your personal credit score, and a default could devastate it. If the worst happens, and your new business fails, you could be facing calls from debt collectors -- and worse -- for years to come.

Clearly, you want to shift that burden from your own shoulders and onto your company's as soon as possible. And you can achieve that by establishing a credit history for your business:

  1. Set up your business as a separate legal entity. Talk to professional advisers to decide whether that should be an LLC, S-Corp, simple sole proprietorship or something more exotic.
  2. Open a checking account in your business's name, and keep yours and its transactions separate.
  3. Get a business credit card, but make sure it's linked to your business's credit report rather than (or as well as) your personal one.
  4. Open accounts with suppliers. If you don't buy in inventory from other companies, you may still be able to open ones with FedEx/UPS and Staples/Office Depot.
  5. Make all payments on time, and monitor your business's credit report, just as you should your own.

Of course, it takes time to grow your venture's credit score. You need to build a long history of responsible money management for it, in the same way you've done for yourself. But, one day, providing you've done a good job, your company should be able to borrow all on its own.

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