Understand how to use a loan to start a business and where to find the best startup money
“Only morons start a business on a loan.” That’s the advice of billionaire Mark Cuban, the rarely at a loss for words owner of the Dallas Mavericks.
While Cuban makes some good points in the interview where this is quoted, he also misses a few points in favor of starting a business with a loan. The 60-year old Shark Tank star hasn’t had to raise money for his own businesses since he was in college when he bought a local bar.
Times have changed and interest rates aren’t what they were in the 1980s. Even iPhone giant Apple Inc, which has $63 billion in cash on its books, owes $93 billion in debt.
Borrowing for business is not only no longer dangerous but might be the smartest financial move you make.
Why You Might Consider Using a Loan to Start a Business
Cuban’s point is that people underestimate the hard work and time it takes to run a new business. He argues that most startups fail and that often means owners are left personally responsible for the money, sometimes at the risk of bankruptcy.
It’s a valid point but there’s another side of the story he doesn’t mention.
The reason most new businesses fail is for lack of capital, not being able to get the money to continue in business. More than three-in-four businesses run for up to five years before running out of money because sales can’t keep up with expenses.
So it turns out that getting a loan might actually be able to keep you in business rather than leading you to ruin.
Of the businesses that survive that first five years, the Small Business Administration reports that many (82%) become profitable and just under half break into the millions in annual sales.
Business loans and other types of loans are some of the least expensive forms of debt in terms of interest rate. Rates on private business loans, for example Lending Club, have come down from above 25% in the 80s to average 13.4% today and loans approved by the Small Business Administration are even lower.
Even a personal loan with an average rate around 14% is below the cost of using credit cards or equity financing to start a business. Equity financing, an ownership stake in a new company through either a partnership or investors, requires a high expected rate of return. Investors aren’t going to put their money down unless they think it will lead to high double- or triple-digit returns.
Business Loan vs Personal Loan
Once you understand the cost of different types of business financing, the question usually becomes either business loan or personal loan.
Business loans almost always offer the lower interest rate because the money is secured by business assets. Lenders can repossess or force you to sell business assets to meet loan payments.
That’s not the case with a personal loan which requires no collateral. You won’t be forced to sell your home or other assets and cannot be pushed into bankruptcy on a personal loan. That peace of mind for the borrower comes at a higher cost of interest.
Business loans are generally at much higher amounts as well. Lending Club funds small business loans up to $300,000 while most personal loan websites will lend $40,000 on three- or five-year terms.
There’s probably no single answer as to which is the best loan to start a business but it might be an unnecessary question anyway. Most new businesses won’t qualify for a business loan.
Minimum requirements for business loans
- 12+ months in business
- $50,000+ annual sales
- No personal bankruptcies or tax liens
Business loans may also require some personal collateral as well so they won’t always protect you from losing your home or other personal property.
By comparison, personal loans are always non-secured and you can use the money for any purpose. Rates may be higher but most people with a 580 credit score or higher can qualify.
Using a Personal Loan for Business Startup
While using a personal loan to start a business may be a good financial decision, there are some things you need to remember before borrowing the money.
Start the business as much as possible on saved money, at least to the point of having a workable business plan and nearing sales. Payments on a loan will begin within a month so you’ll need a way to start making those either through sales or through some of the unspent loan.
If income from the business doesn’t grow quickly enough, you’ll be forced to dip into savings or scramble to make payments.
Startup Business Loan Rule #1: Take the business as far as possible on your own money and only take a loan when sales are near.
I would also recommend only using a personal loan for a low-capital type of business. The internet has opened up the age of low-cost businesses from Amazon FBA to a service website.
For example, it used to cost a minimum of $100,000 to start a retail sales business with manufacturing costs and storefront. Now you can start one with as little as $5,000 through Amazon or Shopify. That means a $10,000 personal loan can give you enough to start the business and have a cash cushion to make payments while sales increase.
This is going to rule out many traditional types of businesses that still costs tens of thousands to get started but it’s by far the safer way to start a business.
Startup Business Loan Rule #2: Only use a loan to start low-capital types of businesses that can be started on $30,000 or less.
Finally, make sure you balance early repayment on the loan with cash needs for the business. It’s tempting to push all cash flow to repaying the loan but it can mean trouble if that cash flow dries up for a few months. You don’t want to fall behind on payments in a dry spell so keep a cash reserve and plan out the year’s expected sales.
Startup Business Loan Rule #3: Plan out the year’s expected cash needs and keep a cash reserve to make loan payments.
How to Qualify for a Business Loan
Qualifying for a personal loan is easy and the application takes less than three minutes. You’ll need a minimum credit score and at least part-time employment to qualify on most websites but that’s generally it.
Getting a business loan is more difficult and will take longer. Most business loans will take at least two or three weeks to approve and process. This includes time to verify financial statements and bank records.
Minimum requirements for a business loan are generally a year or more in business and current sales. Getting the best rates means higher sales in the $100,000+ area and sales from repeatable sources.
Despite the difficulty of getting a business loan versus a personal loan, you should still consider it as a source of funds. You’ll have access to more funds and even a 1% difference in interest can mean tens of thousands in savings.
Getting a loan to start a business isn’t the decision it used to be. With interest rates at historic lows, there are good reasons to consider borrowing to finance your startup. Even multi-billion dollar businesses use debt financing and there are several benefits versus using partnership or investor funds. Weigh the pros and cons and shop your business loan around to make sure you’re getting the best rate.