Many small businesses are dealing with worst-case scenarios during the coronavirus pandemic: Revenue is down as lenders have tightened up borrowing standards.
When a company has maxed out a business line of credit and can’t get a conventional business loan, a personal loan may cover payroll or vendor invoices.
Entrepreneurs can be so passionate that “they will do anything to keep (their companies) going, whether that’s a good idea or not,” says Brooke Lively, president and founder of Cathedral Capital, which provides chief financial officer services for small businesses.
Here is a look at why a personal loan may or may not be a good idea for small businesses.
What Is a Personal Loan?
A personal loan is a fixed amount of money you can borrow for almost any purpose based on your credit history and income. You pay it back with interest over time.
Banks, credit unions and online lenders can give you a lump sum of cash ranging from $1,000 to $100,000 that is commonly repaid over two to five years in monthly installments.
Approval for a personal loan depends largely on creditworthiness, which is a measure of how risky you are as a borrower. If your credit score and income are strong, you are more likely to be approved for a loan with the lowest possible interest rate.
Although personal and business loans are different, both types may rely on an owner’s credit history for approval.
Often, the line between personal and business loans for a company with less than $5 million in revenue “is so blurry that you can’t tell the difference,” Lively says. “Ultimately, everything is going to run off your personal credit.”
If a business is struggling and revenue is down, “An owner might have a better chance of getting a personal loan if a spouse has enough income to make the loan a safer bet for lenders,” Lively says.
Whatever you do, make sure you can use a personal loan for your business before you apply. Some lenders strictly prohibit using personal loans for business expenses.
Is a Personal Loan for Your Small Business a Good Idea?
Using personal loan isn’t a good choice for every business.
Someone nearing retirement shouldn’t take on more debt, for example. But younger entrepreneurs who have taken big hits from the coronavirus pandemic are thinking long term.
They’ll invest because they think “this will be over eventually but might take a bit of time,” says Erica Chase-Gregory, director of the Small Business Development Center at New York’s Farmingdale State College.
Here are a few reasons you might want to take out a personal loan for your business:
Personal loans are flexible and fast. If you need money quickly to support your business’s financial needs, from payroll to vendor expenses, a personal loan might be ideal. A personal loan can take a matter of days compared with weeks or even months for a Small Business Administration loan.
Personal loans are easier to get than business loans. One reason is that you won’t need to put up collateral, as you would with a business loan, to help cover the lender’s risk.
Generally, a business loan is tougher to get than a personal loan, but the pandemic economy has made it even tougher than usual. Lenders are worried that borrowers won’t be able to pay back loans because of economic fallout from the coronavirus.
“They can’t put a lot of money on the street if they’re not going to get it paid back,” says Chase-Gregory.
Personal loans are less costly than many other choices. Entrepreneurs with cash flow concerns might be tempted to take on merchant cash advances or invoice loans, which are tied to sales. “They really need to look at the fine print,” says Chase-Gregory, because the interest can compound quickly.
You might also think about maxing out business and personal credit cards, but personal loans usually have lower interest rates. Still, conventional business loans have lower interest rates and higher credit limits compared with personal loans.
When Is a Personal Loan for Your Small Business a Bad Idea?
If your business model is at risk or your business was struggling before the pandemic, think twice about a personal loan.
“Everyone is looking for loans; everyone is looking for money,” Lively says. “The first question we’re asking people is to take a hard look at your business and figure out if it is a viable business.”
About 20% of businesses said they could operate for seven to 12 months in the current environment, and 19% said they could survive for three to six months, according to a survey by the National Federation of Independent Business Research Center. Also, 58% of small businesses polled by MetLife and the U.S. Chamber of Commerce in the summer of 2020 said they worry about closing.
Even with more financing, your business might have structural problems that lead to failure.
Business owners should look closely at payroll costs, overhead expenses and profits. “They really need to evaluate where they are now and not spend like they did pre-COVID,” Chase-Gregory says.
If sales have dropped, tighten up spending, she says. “Some people continue on their course without changing their business model at all, and that’s when they become cash-poor much quicker,” Chase-Gregory says.
Entrepreneurs tend to look at the best-case scenario, but they also need to consider the worst-case scenario, Lively says.
“If you take out $250,000 in debt right now and your business goes under, what are you going to do?” she asks. “That’s a big hole.”
What Are Some Alternatives to a Personal Loan?
Here are some options to consider:
Equipment loans. If you need to buy equipment, you might be able to get a loan from the manufacturer or a lender that specializes in equipment financing.
Nondisaster SBA loans. The SBA guarantees a portion of bank loans, which means you might have more luck with an SBA loan than with a conventional business loan.
You can obtain 7(a) loans of up to $5 million and use them for furniture, equipment, inventory, real estate and working capital. Alternatively, 504 loans of up to $5.5 million can be used toward real estate and equipment.
Microloans. Microlenders offer SBA-guaranteed loans of up to $50,000.
Also, loans from the Community Development Financial Institutions Fund are focused on businesses in low-income communities. CDFIs are primarily banks and credit unions.
They’re a great choice because they have less stringent underwriting criteria than larger banks, Chase-Gregory says.
Home equity loans or lines of credit. Although obtaining a home equity loan or line of credit is not as quick as getting a personal loan, the interest rates are almost always lower. And your mortgage interest payments might be tax deductible.
Retirement funds. Consider this a last resort because you’ll pay a penalty and taxes on early withdrawals from individual retirement accounts or 401(k) plans, although the government recently eased these rules for coronavirus-related emergencies.
Additionally, if you borrow from a retirement account, you’re losing out on the chance to make money in the market, Lively says.
Negotiating expenses. See if you can negotiate rent payments and supplier discounts.
You could find out if your landlord would let you pay half of the rent and catch up later to get through a tough period, Lively says. Try to extend payment terms with vendors, and work with creditors to reduce payments.