Which is better for funding your company: a personal loan or a business loan? Find out here.
Image source: Getty Images.
From business credit cards to loans to investors, there are a number of ways to get your hands on additional cash to grow your business. Two of the most popular funding options are personal loans and small business loans, especially for business owners who don’t want to turn to outside investors or give up equity. Both are options worthy of consideration, but deciding which one is best for you will depend on the specifics of your business.
You’ll need to take into account that personal loans and small business loans are meant for different purposes and have different qualification criteria. They also impact your credit differently. Here’s what you need to know in order to decide whether a personal loan or small business loan is right for you.
The difference between personal loans and small business loans
Personal loans are guaranteed using your personal credit history. This often makes them easier to obtain than a small business loan if you have good credit, which may look at both a personal and business credit score.
Both personal loans and loans for small businesses come in a range of loan types, from mortgage and auto loans to lines of credit and installment loans. In general, personal loans are meant for personal purchases, whereas business loans are meant to fund business-related purchases.
What can a personal loan be used for?
Personal loans can typically be used for anything. While lenders may ask the reason for your application, in most cases, you don’t agree to spend your loan funds on anything specific when taking out a personal loan.
Some lenders do have restrictions on what their personal loans can be used for, so make sure to read the fine print before applying for a loan. Most personal loans can also be used to pay off existing debt. Some lenders will restrict you from using personal loans for college tuition and expenses.
What can a business loan be used for?
Business loans may come with more restrictions in regards to what they can be used for, such as that you use the funds for business-related purchases. These can include updating technology and equipment, purchasing new inventory, paying for rent on a commercial space, hiring new employees, marketing your business, and even covering your everyday business expenses.
In the end, your business loan should be used for purchases that will generate additional revenue -- ideally, enough to offset the cost of interest. Some lenders will also allow you to use business loans to refinance or pay off existing debt.
Can I use a personal loan for business and vice versa?
You can usually use a personal loan to cover any business expenses. Keep in mind that you’re still personally liable for repaying that loan -- not your business -- and it might be more difficult to separate your finances this way.
On the other hand, some business loans might restrict you from using your funds for non-business expenses. Others are less restrictive and make it easier for you to pay yourself in the form of a salary using your business loan.
How to get approved for a personal loan vs. a small business loan
The approval process is slightly different for personal loans and small business loans. In most cases, it will be easier to qualify for a personal loan, whereas the application process for a small business loan will be lengthier and require more extensive paperwork and documentation.
Getting approved for personal loans
The approval process for personal loans typically requires that you have good credit and stable income. You’ll also have to show that you have a low enough debt-to-income ratio to take on the burden of the loan you’re applying for. If you don’t have good credit, you’ll typically have to resort to secured loans, which require a form of collateral, or loans from non-traditional lenders such as payday lenders, which make up for the additional risk in loaning to people with poor credit by charging sky-high interest rates.
You’re less likely to be approved for large sums of money with a personal loan than a small business loan. Personal loans tend to come in loan amounts ranging from around $1,000 to $50,000. Loan terms on traditional personal loans usually range from two years to seven years.
Getting approved for small business loans
You will need excellent credit to qualify for a small business loan, and lenders may even want to see both your personal and business credit score. You’ll also need to be able to show adequate annual revenue, and most lenders will want to see that you’ve been in business for a while. There are some online lenders that offer more expensive business loans to people who haven’t been in business for very long or don’t have strong business credit scores.
Lenders will also require more paperwork for small business loans, including proof of your profitability and cash flow. You’ll need to specify exactly what the loan is for, and some lenders will ask you to submit a business plan as well. Finally, you’ll need to provide them with information regarding your legal structure and documentation of any required business licenses and permits.
If you qualify for a small business loan, it can be easier to get approval for large loan amounts than it is with a personal loan. Many institutions offer small business loans that range from $5,000 to $500,000 and some even offer loans of over $1 million. Loan terms vary greatly and can range from six months to 25 years.
Advantages of small business loans
Keeping finances separate -- It’s crucial to separate your personal and business finances, and taking out a business loan helps you do this. Not only will this save you a lot of time come tax season, but it could also save you a lot of money in the form of tax deductions.
Limiting your liability -- Depending on your legal structure and the type of business loan you take out, your liability may be more limited than it would with a personal loan in case of default or inability to pay.
Building business credit -- Taking out a business loan instead of a personal loan will help you build your business credit and show future lenders that you can pay your business loans back responsibly.
Larger loan amounts -- If you need a larger loan, you’ll want to consider business loans. Personal loans rarely exceed $50,000, and even that amount can be difficult to qualify for.
Lower interest rates -- If you qualify for the best business loans, you’ll probably get a lower interest rate than you would on a personal loan. According to a ValuePenguin study, the average interest rate for business loans from traditional lenders in 2019 is around 4% to 13%, while the average interest rate for personal loans ranges from 10% to 28%.
Advantages of personal loans
Easier approval -- You might have an easier time getting approved for a personal loan, especially if you haven’t been in business for very long.
Faster funding -- Personal loans tend to require far less paperwork and documentation, so the approval process is shorter and you get your funds more quickly.
No collateral -- The best personal loans are unsecured, meaning you don’t have to put up any collateral to withdraw a loan. On the other hand, many business loans do require you to put up assets in order to secure the loan, especially those with favorable interest rates.
Choosing which personal and small business loans are right for you
Banks, credit unions, and online lenders all offer both personal loans and business loans, and the Small Business Administration also offers government-backed small business loans. Deciding between personal and small business loans and choosing which lenders to borrow from comes down to your business history, your credit, and your business goals.
If you have an established business and want the lowest rates...
Conventional business loans offered by banks and credit unions will typically offer the lowest interest rates. These are ideal, but the application process is lengthy and they aren’t easy to get approved for. You’ll need to have an established business and excellent personal and business credit, and most of the time, you’ll need to have enough assets to put up collateral as well.
If you have a newer or riskier business and want the lowest rates…
Small Business Administration (SBA) loans are an excellent option if you can qualify. These are loans that are originated by a bank but guaranteed by the government. In other words, the government agrees to pay back 85% of the loan if you default.
Because of this, start-ups and riskier businesses that aren’t approved for conventional business loans may qualify for an SBA loan with a bank or credit union, and you typically won’t have to put up collateral. You’ll still get some of the lowest rates on the market. Keep in mind that this process is lengthy and can take weeks or even months.
If you have a brand new business and excellent credit…
Folks who are just getting started and haven’t been in business long enough to qualify for a business loan or an SBA loan might want to consider a personal loan. These can be used for business purposes, and as long as you have excellent personal credit, you’ll still qualify for reasonably low rates. You could also consider financing your start-up with a 0% introductory APR credit card, but make sure that you’ll be able to pay it off before the promotional period ends.
If you need money fast…
Online lenders tend to disburse funds more quickly than traditional banks, and some do offer small business loans. Personal loans are the quickest to fund, with some online lenders offering same-day approval and next-day funding. Pay close attention to rates and terms when it comes to online lenders. They may be fast, but many charge far higher interest rates, so the time you save might not be worth it.
If you have bad credit…
Online lenders and alternative financing often provide loan options for people with bad credit. However, in order to protect themselves against the risk of lending to someone with bad credit, these lenders will charge incredibly high interest rates and may even require collateral on top of that. Options such as payday loans and title loans are some of the worst culprits and are extremely costly.
Small business loans can provide your business with the opportunity to fund growth at low rates and favorable terms. However, don’t be discouraged if you’re rejected for a business loan from a traditional bank. There are plenty of alternatives, from personal loans to SBA loans and online lenders. Just make sure to do your research and opt for low-cost funding options whenever possible.
The Motley Fool owns and recommends MasterCard and Visa, and recommends American Express. We’re firm believers in the Golden Rule. If we wouldn’t recommend an offer to a close family member, we wouldn’t recommend it on The Ascent either. Our number one goal is helping people find the best offers to improve their finances. That is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.