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Startup business loans: How to Find the Best Business Financing

| MoneyRates.com Senior Financial Analyst, CFA
min read

business-little-rocketsNeed money to start a new business? Personal business loans can help get your startup going. The key to using this form of financing effectively is to plan carefully.

Your business financing could determine the success or failure of your startup.

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Why Start a Business With a Personal Loan?

Is a personal loan the right way to fund a new business?

It might be your best option if you lack a business track record. That's because your business offers lenders little to base their decisions on. In that case, your best shot at securing funding may be a loan based on your personal credit history and financial situation.

Your demonstrated debt management ability (as evidenced by your credit score) and means of repaying the loan (your income) drives the lender's underwriting. Your business plan and professional qualifications may come into play for a personal business loan.

When you start a business with a personal loan, you want your business to eventually build its own credit history. So the business can borrow without your personal guarantee.

Personal Business Loans: Start Here

A well-run business depends on advance planning. Planning can help your get your financing and also increase your chance for success.

Start with these steps:

Assess Your Credit

Personal business lenders rely on your credit history. So check your credit score and credit report to spot any potential issues before applying. It can take time to correct problems with your credit history, so take this step early.

A FICO score of 740 or higher is ideal. If your credit score is in the 670 to 739 range, you should also be able to get a loan. However, any steps you can take to up your score should get you better terms and lower interest rates.

If your credit score is south of 670, expect more limited loan options and less favorable loan terms.

Forecast Your Cash Flow

Cash flow is a key to the success of any business. You need to forecast when your revenues will start exceeding your expenses. One reason for doing this is so you can figure out how much financing you'll need to keep your business going until its cash flow turns positive.

Review Your Resources

Before you borrow, look at any resources you have that might lower your financing costs. Selling unused assets could reduce the amount you have to borrow. As an alternative, using assets as collateral could make lenders more likely to approve your loan and offer better loan terms.

Budget Your Payments

Having taken the above steps, you should be able to estimate how much you'll need to borrow and what sort of loan rate you can expect. With that information, you can use a loan calculator to see what your payments would be under different loan structures. This will allow you to figure out how to fit those loan payments into your cash flow plan.

Alternatives to Personal Loans

A personal loan might be the most straightforward way to secure funding to start a business, but this option is not available for everyone. If your credit history and financial situation don't qualify you for personal business startup financing, there may be other options.

Small Business Administration (SBA) loans

The SBA is an agency of the federal government designed to assist small businesses. One of the services it provides is to help start-ups secure funding.

The SBA does this in a variety of ways, including guaranteeing business loans from private lenders and guiding entrepreneurs towards local and charitable organizations that are interested in funding startups.

To find the SBA program that is right for you, a good place to start might be the SBA Lender Match web page. This tool helps match you with interested lenders based on a brief description of your business and its needs.

Keep in mind that start-up loans from the SBA may only be available if you have tried to secure other sources of financing first. SBA loan approval is likely to rely heavily on your personal financial history, and the amount of funding available may be limited.

Home equity loans

If you have equity in your home, a home equity loan or a cash-out refinance could be a cost-effective way to fund your new business.

Mortgage interest rates are generally lower than personal loan rates. And having equity in your home to offer as collateral might help get your loan approved.

On the other hand, mortgaging your home to fund a new business is really doubling-down on your risk. Not only would you be putting your career on the line, but if you fail you could lose your home as well.

Peer-to-peer lending

Peer-to-peer lending sites offer loans from individuals in addition to professional lenders.

Because each loan is funded by multiple individuals, they represent less risk to the lenders and thus peer-to-peer lending might increase your chances of getting approved for financing.

Your personal credit history may be a big factor in appealing to peer-to-peer lenders, so this may not be a solution if you have poor credit. Also, watch out for platform fees when you use a peer-to-peer web site, because these may add considerably to the cost of your loan.

Crowdfunding

Crowdfunding provides capital directly from individuals to people who need money for a specific reason, one of which may be to fund a start-up.

Some crowdfunding programs provide money strictly as a donation, while others seek either goods and services in return or require an equity stake in the new business venture.

Depending on the method of reward required in exchange for crowdfunding, it can be difficult to assess the true cost of that funding compared to the interest on a personal loan. Also, there may be platform fees which add to the cost of this method of financing.

How to Choose a Startup Loan

Your advance research should tell you how much financing you need and how qualified you are. Now you can compare personal business loans to see which offers the best terms.

A little comparison shopping can focus your search on the best possibilities and avoid unnecessary applications. Besides being time consuming, applying for multiple loans could affect your credit score and you might incur application fees.

Here are the key characteristics to look at when comparison shopping for a personal business loan:

Term

Longer loans typically mean lower monthly payments - but also higher interest rates and more total interest expense over the life of the loan. Look at loans of the same length so you can compare apples to apples.

Interest Rate

Unless you have great credit, don't expect the best rate each lender advertises. If you have shaky credit, the rate you get is more likely to be toward the higher end of the lender's range.

Underwriting

Before you apply, talk to representatives of the lender to assess your chances for loan approval. See if they offer a prescreening or preapproval process so you can get an indication of the outcome without it affecting your credit score.

Application Fees and Loan Costs

Focus on the annual percentage rate (APR) of each loan, which includes both interest and any fees on the loan. Lenders are required to disclose this information.

Fees can add considerably to the cost of a loan, and APR enables you to put both interest rates and fees into perspective for comparison purposes.

Personal Business Loans: How to Apply

Once your research produces a shortlist of possible lenders, here's how you should go about applying to them:

Clean Up Your Credit Report

Take one last look at your credit report before you apply. See if the problems you've been working on have been resolved and make sure there have been no unexpected developments since you last checked.

Know Your DTI (Debt-to-Income)

The ratio of debt-to-income is considered an important indicator of your ability to repay a loan. The DTI ratio is the ratio between your before-tax income and your debts. The DTI does not include living expenses like utilities and food.

Lenders calculate a DTI by dividing your total monthly account payments by your gross monthly income. Your mortgage, property taxes and homeowners insurance (or rent if you don't own your home) are included in those expenses. Here is an example:

  • Rent: $1000 per month
  • Car payment: $300 per month
  • Credit card minimum payments: $200 per month
  • Payment for new business loan: $500 per month
  • Gross monthly income: $6,000 per month
  • DTI equals ($1,000 + $500 + $300 + $200) / $6,000

The DTI would be $2,000 / $6,000, or .33. That's 33%.

A ratio below 36% is most attractive to lenders. If your DTI ratio is between 37% and 50% you will probably need to have other factors in your favor. And even, then you probably won't get the best loan terms. A DTI above 50% makes it unlikely that you will be approved for a loan.

Create a Business Plan

A business plan could help your chances of being approved for a loan. Lenders won't want too much detail, but a summary of how you intend to make your business succeed and any relevant experience and expertise you have could help make your case.

Plan Carefully, Act Swiftly

If you apply to multiple lenders, try to send these applications at more or less the same time. That way these applications will be viewed as a single attempt to borrow rather than as someone seeking multiple sources of credit. This will minimize the impact on your credit score.

After you've obtained your startup loan, keep in mind that businesses often have ongoing needs for credit even beyond the startup phase. Making your payments on time and in full will help your business obtain additional credit in the future.

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