From small business loans to credit cards to investors, there are various options to get your business funded and grow it. For some, a business loan is an appropriate option, and personal loans remain a common and feasible option to fund your small business. In order to make a decision before choosing one, there are pros and cons to both financing options. This is particularly essential for new business owners, who need to think and weigh carefully while deciding on these two financing options.
It’s important to scrutinize the potential outcomes and repercussions before making a business decision. How you will use the funds, how it weighs on your credit score, the loan underwriting process and how to build a financing relationship for the future of your business.
Here is everything you need to know before deciding which loan option is more suitable for your small business—so you’ll be able to make an intelligent decision in order to get the capital to grow your small business.
Primarily, let’s dive in to understand the difference between business loans vs. personal loans. Both loan options offer multiple products including lines of credit and term loans. However, the actual loan usage tie back to the business itself. For what reason you need a loan for and how do you plan to use it.
The Use of a Business Loan
You can use a business loan for almost any business purpose from buying inventory, renovation, salaries, marketing to open a new location, or even buy business equipment. With that said, you’ll need to have a detailed plan on how you will use a loan and for what purpose.
There are different types of business loans and some with specific purposes. For instance, equipment loans are for financing equipment purchases, lines of credit for emergencies and stalled cash flow, and invoice factoring for your accounts receivable. Other options have little or no constraints on them. So, the structure and terms of your loan will be determined by your loan usage.
The Use of a Personal Loan
A personal loan is lump sum money borrowed which you repay in fixed monthly installments and use as you see fit. There are different types of personal loans based on how you’ll be using the money.
Personal loans are alike business loans with one difference; they’re for personal use. With that said, it’s significant to have your personal and business financials separate while running a business. Personal loans are usually used for things like credit card debt consolidation, medical bills payment, home upgrades, or to finance a car purchase.
Use of Business Loans and Personal Loans Interchangeably
Technically, you can use them interchangeably. Money is money and as long as you’re using a loan within the terms, you can do whatever you want with it.
However, there’s a risk involved while using them interchangeably. If you default on a loan, the lender can seize collateral from you personally, rather than your business, or vice-versa. So, you need to very careful before using a loan interchangeably.
The Approval Process
The loan approval process is the main difference between business loans and personal loans.
In a personal loan underwriting, lenders consider two important factors including your personal credit history and personal income. The rest of the factors like your loan terms, interest rate and loan amount all depend on these two factors. With a strong credit profile and income, you can easily secure a personal loan.
In the case of business loans, lenders take into account a variety of factors while making a decision. Your personal credit history serves as your financial report to lenders making the most important factor in the decision.
However, this is just one part of the puzzle. Lenders also take into account other factors like business profitability, time in business, debt to income ratio, cash flow, collateral, and industry while deciding whether to approve you funding or not. All these factors contribute to the finalization of the interest rates, terms, and amounts of a business loan.
How to Decide Which Option to Choose?
For many business owners, getting a business loan for business and personal loans for personal purpose rule works. While for some, it’s not quite that straightforward. Here are a few tips to help you decide which option to choose:
Get a business loan when you want:
- To keep your business and personal finances separate
- To limit your accountability
- To improve business credit
- To apply for a higher loan amount
- To build a connection
- Something other than a term loan
There are many reasons to get a business loan rather than a personal loan. Let’s dive into each situation to understand why getting a business loan is a better option.
To Keep Business and Personal Finances Separate
Your business finances can get tangled up with your personal finances. Keeping them separate will not help you avoid problems, but also greatly simplifies things and makes it easier to manage your finances—enabling you to stay on the right side of the law as well.
This also helps your accountant at the tax time, and get you all the legal protections when your business needed. With that said, you need to have a business bank account, if you’re pursuing a business loan for business-specific financing.
To Limit Your Accountability
Based on your business entity type, your liability changes with regard to a business loan and a personal loan. If you’re registered as a limited liability company (LLC), you’ll not be personally held liable for any business’s debts and obligations.
To Improve Business Credit
As a new business, your personal credit history will be a main factor in the loan underwriting process. However, getting a business loan will help you improve and build your business credit. This also demonstrates future lenders that you’re capable to afford the loan and repay it on time.
To Apply For a Higher Loan Amount
With a business loan, you can obtain cash up to $500,000, since business expenses cost more than personal expenses. On the contrary, personal loans are for personal things and you’ll not get one more than $50,000 in the loan. After all, besides mortgages, there are no reason of getting a loan in excess of $50,000.
Need Something Other Than a Term Loan
Personal loans are term loans that you repay over a certain period with interest. Business loans, on the other hand, offer a variety of products at different terms and rates. Whether it’s business credit lines, invoice factoring, merchant cash advances, equipment financing, or term loans, you can choose the loan product based on your needs.
To Build a Connection
Visualizing your business becoming a million-dollar company is easy. Whereas, portraying how much funding will be required to get it isn’t as easy—but it’s likely that you’ll need it.
Building a strong connection is among the major factor when choosing a business loan. A lender builds a relationship with the borrowers just as your customers build a relationship with your business. So, when your business needs funding at better terms and rates, having a relationship with a lender that knows you better will help.
On the other hand, personal loans don’t help in building a connection. Because they’re often used as a quick fix to a one-off problem.
Get a personal loan when:
- You’re a new business
- You get a lower rate
- You have a lot of savings
- You need quick money
- You don’t want to offer collateral
- You’re ready to risk your personal credit
Now that you know the situations where getting a business loan can help, let’s explore the situations where a personal loan can be a better fit:
- You’re a New Business
Many new business owners are searching to secure startup financing to get off the ground. However, the reality is that getting a startup business loan is difficult with requirements like a few months of time in business and good personal credit. In such cases, getting a personal loan can help.
With a personal loan, you can get a lump sum deposited into your account, and allow you to kick-start your growth along with building your business’s credit history.
- You Get a Lower Rate
In some cases, a personal loan can get you a lower rate as compared to a business loan. Getting low-cost capital is ideal especially for new businesses. Moreover, if your personal credentials are solid, you can easily secure a personal loan at the lowest possible rate that can easily beat cost of a business loan you can qualified for.
- You Have a Lot of Savings
With good savings and high income, you’ll likely get a better rate on a personal loan than you would on a business loan. Again, it’s best to obtain low-cost financing.
- You Need Quick Money
The application process for a personal loan is simple and easy as compared to a business loan, you can likely get quick approval for a personal loan. It’s also another benefit while deciding which option to choose between a business loan and a personal loan.
- You Don’t Want to Offer Collateral
Another major benefit of personal loans is that they’re unsecured, meaning you don’t have to provide any collateral or personal guarantee in order to secure one. This is particularly beneficial for new businesses that are required to offer collateral due to no time in business or good credit standings.
- You’re Ready to Risk Your Personal Credit
If you default on a personal loan, not only your personal credit score will hurt badly, but also affect your ability to obtain financing at affordable terms and rates in the future. In case of a business loan default or late payments, only your business credit score will get the hit.
The Bottom Line
Expectedly, now you know the situations with clarity around which loan option to choose between a business loan and a personal loan. Now the next step is to assess the loan type that is a best fit for your small business. Before finalizing a loan option, make sure you’ve considered the impact on your credit scores, and on the future of your business. Understanding and following all these things will surely help you laid out a solid foundation for the success of your small business in the future.