Both personal and business loans can help your business promotion at certain stages of its development. If you're just launching your own small business and have no business credit yet, you may consider getting a personal loan to purchase all the stuff you need to get started. If you already have a successful business but want to bring it to a new level, a business loan can also be a great investment in your bold ideas and goals.
But unfortunately, both personal and business loans always come with risks. And we're going to talk about them in this article. Hope this will help you assess your financial risks thoroughly before going into debt.
Are Loans a Good Solution for Your Business Financing?
Well, all there is a cure, and all is poison, only dose matters. When it comes to loans, the "dose" is the way you use the amount borrowed along with your current financial situation. Sometimes a loan can be a good debt that will push your business and help it succeed. However, you need to fully understand what you're getting into and know what you need the money for. Below are some examples of good loan usage for business:
- Equipment and inventory purchases;
- Buying real estate;
- Building or improving a business credit score;
- Consolidation or refinancing of existing debts.
However, before you request a business or personal loan, be realistic about what you're dealing with. Assess the risks that come with loans and make sure you can take them or know how to minimize them.
5 Main Risks of Getting a Business Loan
Below are some common risks that businesses may face after getting a loan.
Cost Fluctuation
Business loans work like any other loan option. Along with their principal, borrowers also need to pay lenders' fees for using the money. These costs are called interest rates, which are expressed in a percentage of your loan amount. Interest rates are charged for the whole year of using the loan, but you repay them monthly. Each of your loan payments goes toward both the principal balance and interest repayment.
While some loans have fixed interest rates that are not changed over the whole loan term, others come with variable rates. These rates can fluctuate during the term of your loan under certain market conditions or at the lender's discretion. At the same time, variable-rate loans usually have a lower initial interest rate, making them more attractive for businesses. However, you need to always keep in mind that variable rates can lead to higher payments in the long run. It's also hard to plan your budget when you don't know for sure how your loan will behave.
Personal Credit Damage
New businesses typically don't have business credit, so their owners are often forced to use their personal credit scores as a loan guarantee. This way, you need to be ready for a hard credit check and think about improving your personal credit score in advance. Until your business doesn't establish a profitable history or credit records, your personal credit score is one of the major determining factors. And it comes with several personal risks that owners have to take.
First, if the business doesn't repay the loan, its owner will be responsible for repaying it instead. Additionally, any business loan late or missed payments will be displayed in your personal credit history. Thus, your personal credit score can easily go down, holding you back from getting a mortgage or a car loan in the future. Latoria Williams, the CEO of 1F Cash Advance, states that business loan failures are among the common reasons why people seek help from alternative lenders when they can't qualify for traditional loan options. Therefore, think twice before taking this risk and try to create a clear repayment plan.
Defaults and Their Implications
Default is the act of any violation of repayment time limits. It includes missed payments and late payments. In both cases, it will indicate your business's insolvency, so lenders won't be willing to work with you. Even if you just were so crazy busy and unable to keep track of your due dates, a lender will be more likely to think the business is simply struggling to handle your loan payments.
A defaulted loan follows the company for up to 10 years, negatively affecting its future credit opportunities. Plus, it damages a company's credit score and can't be simply removed from its business credit report.
Collateral Repossessing
This risk occurs when it comes to secured business loans. These loans are popular with businesses that can't qualify for unsecured loans due to unsatisfactory credit records or the absence of credit history. Sometimes secured loans are also used to get a higher loan amount or more favorable loan terms, for example, lower interest rates or extending repayment schedules.
The main thing you need to know about a secured loan is that you must provide collateral in exchange for the amount you need. Collateral is any valuable asset the business owns with a value that equals to or exceeds the requested loan sum. Some assets that a business would use include but aren't limited to:
- Equipment and inventory;
- Real estate;
- Investment or savings account balances;
- Land.
When you use a business's property as a pledge, you provide a lender with partial ownership of this asset. This is made in order to secure the loan, so your collateral serves as a repayment guarantee. What does it mean to you and your business? If you default on a loan or file bankruptcy, the lender will have the legal right to seize your property and sell it to cover financial losses.
Overburdening
Yes, we know it's great that your business can access multiple financing options for its development. But just because you can get many loans doesn't mean that you should do it. Although it can help you build credit, provided that you repay the money on time, taking out several loans within a short time frame also comes with some unwanted consequences.
First, you increase the financial burden along with the amount you overpay in interest. Thus, you can easily find your business in debt that becomes hard to manage. The best scenario is when you pay off the existing loan and then get a new one. But if you try to manage several loans at a time and apply for another loan, a lender may think your company faces serious financial challenges.
This way, a lender may wonder whether your business makes a profit or it just struggles to keep itself afloat. Additionally, it raises a question about the owner's money management skills. This is because when it comes to business, loans should serve as a financial tool for its development and growth. If it doesn't happen, and a business is forced to go into another debt to survive, a lender will think twice before dealing with you.
Personal Loan Risks
If you're going to take out a personal loan to start your own business or use the money to develop the existing one, keep in mind that risks can occur too. Here are some challenges you should be ready to face when you go into personal debt.
High Interest Rates
Interest rates on personal loans now range between 5.99% and 35.99% per annum. The exact rate you can get depends on multiple factors, but your credit score is typically the most important one. The higher your personal credit rating, the lower the interest rate you can get. In its turn, lower interest rates result in less overpayment.
But if your credit score is low, you may be either offered a higher rate or even denied a loan. This way, you may be forced to turn to bad credit loan lenders that offer extremely high rates in order to prevent financial losses. This way, you risk ending up with monthly loan payments that you can't afford.
Origination Fees and Prepayment Penalties
A personal loan cost is not only about paying interest rate in addition to your principal loan amount. Lenders often charge extra fees for loan processing or under some conditions. Thus, you need to figure out whether the lender you're going to deal with applies any extra fees and how much it will cost you.
For example, origination fees may be around 1%-5% of your requested loan amount. This sum will be deducted from your principal, so you need to be ready to get less money than you probably expect. Also, there may be prepayment penalties that occur when you repay your loan early. Plus, most lenders also charge extra fees for late and missed payments.
Unnecessary Spending/Overspending
It is especially true for credit card debt, which provides you with a revolving line of credit, allowing you to use the money in any store where a credit card can be accepted. This way, you may end up buying some unnecessary things or covering your personal needs instead of using money for your business purposes.
This can also happen if you get approved for a higher personal loan amount than you need to reach your business goals. This way, you can use the remaining amount for your personal wants, increasing the financial burden and your debt-to-income ratio.
Credit Score Damage
Like with business loans, defaulted personal loans affect your credit score directly. If you pay late or miss your monthly payment, your lender will report this to major credit bureaus. This way, your credit score will drop, and the corresponding record will appear in your credit report. Thus, if you want to take out another loan in the future, you may find it more challenging. At least, you may be offered higher interest rates than those on your existing loan.
How to Minimize Risks of Small Business Financing?
Although loans come with certain considerations, sometimes they can be a solution that you can't go without. Below are some useful and practical tips on how you can minimize the risks associated with small business financing.
Compare Offers
There are plenty of lenders to choose from, and they are not created equally. Each lender may offer its benefits for using its services but also has its flaws to consider. We recommend you to pre-apply for a loan from several lenders and compare their offers before deciding on one. Pay attention to interest rates, fee amounts, additional services, and other loan conditions. This way, you can rest assured that you choose the best possible option for your situation.
Be Realistic
First of all, make sure you really need a loan. Not all purposes and financial goals require you to go into debt. Sometimes it may be more reasonable to wait a bit and save money for your needs than taking out a loan and overpaying.
Also, assess your credit score to understand what interest rate you can expect to get from lenders. Fully understand what you're going into before getting a loan to be ready for the consequences they may potentially bring to your financial life.
Improve Your Credit
No matter whether business or personal, a credit score is an important part of the loan-getting process. If you want to borrow money at favorable terms, your credit rating should be high. A good personal credit score typically starts from 670 but depends on a specific credit bureau and its scoring system. A business credit score is a number from 0 to 100 (except for the Equifax scoring), so a rating of 80 and above typically indicates a low-risk business.
To improve your credit score, pay attention to factors that affect it. In most cases, you need to pay your monthly bills on time, avoid late loan payments, and maintain a low debt-to-income and credit utilization ratio.
Have a Clear Plan
It can be applied to both a loan purpose and a repayment plan. Before getting a loan, you need to understand how you will use your money and what business needs will be covered with it. Never obtain a loan just in case, as it comes with the risk of unnecessary spending.
Additionally, you need to know how you're going to repay your loan. Therefore, you need to make an accurate calculation, assess your business cash flows and expenses, and only get a loan if you see that your business can afford it.
Bottom Line
Loans can be a great financial solution for developing your business. However, both personal and business loans come with risks and should be approached cautiously. Knowing the risks can help you put down a pillow to save your business from unwanted consequences.