Many prospective business owners are surprised at how difficult it is to obtain initial financing through a traditional lender. Most financial institutions require a strong business credit score and history of timely payments. Regardless of the strength of your business plan, banks may reject your loan request because your business hasn’t established enough financial credibility. Entrepreneurs who can’t get business loans, or who would prefer to avoid the hassle of seeking them out, may prefer to self-finance their startup.
However, just because you’re spending your own money or equity doesn’t mean that there’s no risk involved. In fact, some methods of self-financing may expose you to severe financial consequences if the business struggles or fails.
Take a few moments to familiarize yourself with the pros and cons of the financing tools below. As is often the case, you should consult a financial professional or attorney before making decisions on funding your business.
Using Your 401(k) to Start a Business
First-time entrepreneurs who have spent years building a sizable retirement portfolio might be tempted to cash in their savings for the sake of their new business venture.
Bypassing banks and accessing your 401(k) can be a complicated and risky move, but if you have ample funds in your retirement account and you strongly believe that your new business is a solid investment, there are several options available.
1. Make a Loan to Yourself
Many retirement plans allow participants to borrow money against their vested balance. 401(k) loans are limited to $50,000 or 50 percent of these funds, and the loan must be paid back in full within a certain amount of time, amortized quarterly. If you’re unable to pay back your loan within the specified timeframe, you can face stiff penalties from the IRS, so tread carefully. Should you become separated from your employer, it can require that the loan be repaid immediately. You should not take a loan from your retirement plan unless you’re confident you can repay it under these circumstances.
2. Take the Money & Run
Alternatively, you can withdraw money directly from the account. You can arrange penalty-free distributions after you’ve reached 59-1/2 years of age. If you’re any younger than this, you’ll pay income tax and a certain percentage penalty on the early withdrawal. In that scenario, accessing your 401(k) can be a very expensive option. You may be able to avoid the tax and penalty by re-investing your 401(k) in your business through a method known as “Rollover-as-Business Startup,” or ROBS, but this is a complex move that should only be attempted with the assistance of a financial professional.
Home Equity Loans for Business
A home equity loan is one of the personal loans options that can provide a substantial amount of money (depending on the property and how much is owed on it). In most cases, the funds can be provided as a lump sum or a line of credit. Home equity loans do not have restrictions on how the money can be used, so this makes them popular among some first-time entrepreneurs who have established equity in their homes. A quick infusion of cash may be just what you need to get a business up and running. But remember – even though you’re borrowing against your own equity, the money must be repaid.
Betting the House
Unfortunately, home equity loans come with a potentially devastating risk – the loss of your home should you default on the loan. You’re using your house as collateral, and that means lenders can seize it to recoup loses. Because of this risk, you should speak to a financial professional – and the people you live with – before making a decision about a home equity loan.
Using a Personal Credit Card
When a business doesn’t qualify for a traditional loan, entrepreneurs may be tempted to fall back on personal credit cards to access capital. It can be especially tempting if the individual has a high credit limit and can borrow at a low interest rate. Personal credit cards may be able to cover some costs if you operate a business with low overhead.
But there can be unforeseen consequences to mixing your personal and business credit, not the least of which is exposing the business owner to liabilities that may have otherwise fallen on the corporation. Carrying a large balance can also weigh against your personal FICO® score, which may negatively affect your ability to get loans in the future.
In addition, relying on a charge card won’t help the company establish business credit of its own. While this method may provide much-needed funds, it can be shortsighted.
Funding Your Startup with a Life Insurance Loan
Many whole life insurance policies gain cash value over time, and this can typically be accessed by the policyholder after 10 years. While the process differs depending on the insurer, it can be relatively easy to withdraw a percentage of the policy’s value through a loan.
Your collateral is essentially the policy itself, and the loan amount – along with interest – is deducted from its overall value. There’s an additional aspect of life insurance loans that some business people may find attractive: you don’t have to pay them back. However, this is where some of the danger lies.
Let’s assume you only pay the interest charge each month, but never tackle the principal. At the time of your death, it’s the principal amount that would be deducted from the death benefit your beneficiaries receive. If you don’t make any payments, you lose the principal value AND the accrued interest. This is a case where the power of compound interest can work against you. In the worst-case scenario, the value of your policy is completely depleted and you can lose coverage altogether.
Risk vs. Reward
There is no such thing as a one-size-fits-all solution to funding a small business. The level of risk that a person can accept depends on many variables, and what seems foolhardy to one entrepreneur may be tolerable to another. The four financing methods discussed above may pay off for some new business owners. The bottom line is this: borrowing money comes with risks, and it’s crucial that you understand the potential consequences before signing on the dotted line. If you’re thinking of utilizing any of the above techniques, it’s a good idea to consult with a financial professional for personalized advice.
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