Do you have big plans for 2017, such as starting a new line, hiring additional employees, or expanding to another location?
If you need capital to make your vision a reality, borrowing may be a good option.
Your relationship with the lender is finite because once you repay the loan you can part ways. The cost of borrowing is still relatively low: the prime rate to which many loan rates are tied is only 3.75%. And business interest is fully deductible.
Here are 10 places to look for loans, and the upside and downside of each type of borrowing:
1.Family/friends. In the old days this used to be called Rolodex financing, because you looked at the collection of phone numbers on your desk and approached those who you thought could afford to help you. Today, you can look through your smartphone’s contact list and do the same thing.
- Upside: Because these lenders know you, there’s no credit checks and loans usually come with very favorable terms, including little or no interest, and flexible repayment terms.
- Downside: If you fail to repay, you can create hard feelings that may severely damage relationships. Also, unless you have a written promissory note with arms-length loan terms, the IRS may disallow an interest deduction on the grounds that the money was a gift and not a loan.
2. Home equity. The housing collapse dramatically depleted the equity that many owners had in their homes. Now, after almost 10 years, many have seen the equity grow, and they are able to borrow against it.
- Upside: You may be able to borrow up to 80% or so of the equity. And interest rates on home equity loans are lower than rates charged on commercial loans. Also, you may have repayment options (depending on the type of home equity loan), such as interest only for a set number of years, and no prepayment penalties.
- Downside: If you fail to repay, you could lose your home. You usually need a good FICO score. One report found the average FICO score to be 774 for loans made in 2015.
3. Retirement plans. If you have a 401(k) plan, you may be permitted to borrow from it.
- Upside: Loans typically can be arranged in a matter of days. Interest rates are relatively low (the IRS considers prime plus 2% to be reasonable). Repayment can be spread in level amounts over 5 years, with no penalty for paying it off early.
- Downside: You can only borrow up to the lesser of $50,000 or 50% of vested benefits. And you lose the tax-deferred growth on the funds that you could have earned if you hadn’t taken a loan.
Caution: You cannot borrow from an IRA. If you pledge your IRA as collateral for a loan, it’s treated as a taxable distribution.
4. Credit unions. If you are a member of a credit union, you may be able to get a business loan. Business lending from credit unions has been growing significantly.
- Upside: Rates and fees are lower than commercial lenders because credit unions are nonprofit organizations (owned by their customers). Loan approval is local, which can make the lending process quicker than with commercial lenders
- Downside: The loan process is still a formal affair, requiring you to produce three years of tax returns, financial statements, and a business plan showing what you plan to do with the money.
5. SBA loans. The SBA doesn’t lend money directly (except for certain disaster loans); it provides guarantees to commercial lenders to induce them to make loans to small businesses. There are different SBA loan programs, depending on what the loan is used for.
- Upside: Lower down payments and longer repayment terms than conventional business bank loans.
- Downside: There are caps on the amount that can be borrowed through each program. These loans still entail fees and expenses, and may take weeks or even months to close.
6. Online loans. There are a growing number of online borrowing options. Typically online loans are lines of credit, but they can be term loans (usually short term or accounts receivable financing). While some have been exposed as shady operations, others are valid options for small business owners seeking a loan.
- Upside: These offer 24/7 access, with quick loan approvals. Usually only a modest amount of paperwork is required.
- Downside: Interest rates may not be as favorable as other borrowing options.
7. Accounts receivable financing. In the old days this was called factoring. Today it’s also called invoice financing. It’s a borrowing option where a third party (the factor) buys your outstanding accounts receivable for business customers at a discount; the discount represents interest and fees you pay for this borrowing arrangement. More specifically, you receive an advance of up to 80% or so of the face of the receivables, and the balance, minus the factoring cost, when the accounts are collected.
- Upside: The approval process is fast and you have flexibility on which invoices to factor. The interest rate charged on the outstanding receivables depends on the credit worthiness of your customers with the outstanding invoices and not on your credit rating.
- Downside: The cost of factoring may be higher than other types of loans.
8. Clients, customers, and vendors. Similar to borrowing from family and friends, you may be able to get a loan through your business relationships. For example, if you need money to buy a piece of equipment, the seller may be able to finance the purchase, with the equipment as collateral. The same upside and downside for borrowing from family and friends applies here.
9. Crowdfunding. This option, also called crowd lending and peer-to-peer lending, allows you to borrow a little amount from a lot of people through an online portal to get the capital you need. You can find a listing of some top debt crowdfunding sites here.
- Upside: It can be used for startups as well as established firms. Interest rates are fixed according to what the borrower wants to pay and the lender wants to receive; an interest is fixed when the loan is finalized.
- Downside: There’s no guarantee you’ll attract lenders willing to help you with your vision.
10. Pawnshops. You take a piece of equipment or a family antique to a local pawn broker and you can get immediate cash. The amount of the loan is a discount to the value of the item pawned.
- Upside: No credit check is needed.
- Downside. The downside is the high rate of interest. While most states regulate it, the interest is set per month, which can significantly add up for a loan outstanding for several months. There was one Pawn Stars episode where a small business owner pawned his motorcycle to get cash to meet his payroll. If a comparable receivable could be collected within the month so that he could pay off the loan and recoup his motorcycle, then this strategy made sense in this situation.
Before you go out and look for a loan, consider your alternatives: bringing in new investors, self-financing by creating a sinking fund for future business projects, or finding creative ways to raise cash (e.g., contests). If you decide to go the debt route, be sure you have sufficient cash flow to service repayment. Talk with your tax, financial, and legal advisors before you do anything.