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Launching a small business is no easy task. They require a ton of time, patience, planning and often, a lot more money than you may have anticipated. Fortunately, there are funding options that aspiring small business owners can turn to. Two of the most common are small business loans and personal loans. And while they may seem really similar and practically interchangeable, there are actually some very important reasons why you might want to choose one over the other.
Select spoke to financial expert Ashley Russo to breakdown when it may (and may not) be beneficial to take out a personal loan to start your small business.
What is a personal loan?
A personal loan is a line of credit that typically gets used for large purchases. Much like the name suggests, a personal loan is personal, meaning it can be used to cover the cost of anything that’s important to your personal circumstances. This could be home renovations, a wedding, funeral expenses, moving costs, emergency expenses, and more.
There isn’t really a hard-and-fast rule about what the loan must be used for (though, you’ll usually have to explain your plan for using the money when you apply for the loan). You can even use it to pay off multiple credit card debts – this way, you can essentially “consolidate” your credit card debts into one personal loan that you’ll pay off.
Personal loans typically carry a much lower interest rate compared to credit cards. For reference, the current average APR for a two-year personal loan is 9.58% while the average APR for a credit card is 16.30%, according to the Federal Reserve.
For the most part, the interest rate you’ll be charged will depend on your credit score. And while different lenders have different minimum credit score requirements for approval, the higher your credit score, the more likely you are to have a lower interest rate and more favorable loan repayment terms.
Another important distinction is that personal loans usually have a set repayment period. This can range from a few months to a few years. And depending on the lender, you may be charged a fee if you pay off the loan early, before the repayment period ends. Some lenders will also charge an origination fee, but if you want to avoid this you can search exclusively for loans without one, like the Discover Personal Loan.
For a better idea of what other personal loans are out there, you might want to browse our list of the best personal loans.
Information about Discover Personal Loans has been collected independently by CNBC and has not been reviewed or provided by the bank prior to publication. Discover Bank USA is a Member FDIC.
Annual Percentage Rate (APR)
Debt consolidation, home improvement, wedding or vacation
Early payoff penalty
A small business loan is similar to a personal loan, but it is meant to help entrepreneurs get funding for a variety of costs that arise from running their business. Some of these loans may be applied for through the U.S. Small Business Administration (SBA), however, you can also apply for small business loans through commercial banks, community banks, peer-to-peer lenders like Funding Circle, and online lenders like Kabbage.
There are also a few different types of business loans. A small business line of credit gives you a certain amount of credit that you can pull from and receive as cash, and you’ll pay interest on what you borrowed (kind of like you would with a credit card). And working capital loans are meant to help you cover the everyday costs of running your business – like payroll and rent for your office or work space. Those are just two types of loans to consider, but there are also other types of business loans that may be better suited for you needs.
Can I use a personal loan to pay for expenses for my small business?
The short answer is yes, a personal loan can also be used to cover expenses associated with starting a small business.
“Once you’re approved for a personal loan, you can use it in any way that makes sense to,” said Ashley Russo, a Financial Planner and Educator. “If you’re starting a small business, you can use the personal loan to cover anything from inventory to payroll to rent. But you might consider doing it at the lowest possible cost to you, which means taking out the loan with the lowest possible interest rate.”
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So you now have two really great options for funding your small business. But there are a few things to consider when figuring out which type of loan is a better fit for you.
Keep in mind that when you go to apply for a small business loan, some lenders may ask you for a few business-related documents before you can be approved.
“Some banks will require tax returns or pay stubs for your business, or they might ask you to provide a business plan,” Russo said. “With personal loans, on the other hand, you don’t have to show any business interest to be approved for a loan.”
You can simply ask the lender if you can use the personal loan for business purposes. It’s better to be upfront about your intentions to make sure you aren’t breaching any loan terms; using a loan for prohibited purposes could result in the lender forcing you to repay the full amount plus interest immediately.
Additionally, if you don’t have any collateral that can be used to secure your business loan, you may instead opt for an unsecured personal loan. A secured loan means that if you fail to make payments, the lender can seize an asset (your car, house, or in terms of your small business, this could be your inventory) that you provided as collateral. Some small business loan lenders will require you to secure the loan with an asset, whereas personal loans are typically unsecured.
Another thing to consider is how much money you plan to borrow. Most SBA loans allow you to borrow up to $5 million for business expenses. Most personal loan lenders will approve you for up to $100,000.
When might it make sense to apply for a small business loan?
The limits on the amount you’re allowed to borrow for each loan is a very important consideration. If you think you’ll need more than $100,000 to get started, you might consider applying for an SBA loan since they have higher maximums. Creating a business plan and budget can help you pinpoint what your exact needs may be.
Also, keep in mind that personal loans are tied to your personal credit history. So if you fall behind on payments, your personal credit score can suffer, and that can make it harder for you to get approved for other lines of credit like a new credit card, car loan, or mortgage.
Both personal loans and small business loans are effective ways to cover expenses to get your small business off the ground. Your choice may come down to how much money you actually need, where you can get the lowest interest rate and whether or not you want to put your personal credit on the line.
If applying for a personal loan, be sure to read through the conditions of the loan beforehand to make sure you can use the loan for business purposes; if it isn’t clear, you should ask the lender directly. Also make sure you spend some time hatching a business plan and a budget that can help you clarify your needs.
“It’s hard to know where you’re going if you don’t know where you are,” Russo said. “When creating your business plan, figure out your expectation for revenue and know how you’re going to pay back the loan before you even apply.”
Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.