Businesses need funds to fuel growth, and in most cases there are only three places where those funds can come from. One source is new sales revenues, another is equity investment (selling shares of ownership in return for funding), and the third is loans.
Where things can get tricky is in understanding and evaluating the different types of loans in order to choose the one that best meets your needs. For many small business owners, this is accompanied by another question: Should I seek a commercial business loan for these purposes, or should I apply for a personal loan myself and then apply the funds to help my business?
Business Loans & Personal Loans: The Key Differences
Let’s begin by understanding the fundamental difference between the two. A business loan is a loan made directly to the business, and is evaluated and offered based (primarily) upon the credit, assets and repayment capacity of the business. In contrast, a personal loan is one made to you personally, and is evaluated and offered based upon your personal credit, assets and repayment capacity.
However, many business loans actually blur this distinction by involving both business and personal creditworthiness and contractual obligations.
It’s important to understand that a ‘true’ business loan is one that stays on one side of the ‘corporate veil’, which is the legal line that separates you from your business (assuming you operate a ‘C’ or ’S’ corporation or an LLC). This distinction is designed to protect you and your personal assets (like your home) from being at risk should the business fail to meet its obligations…and it is one major factor in favor of keeping loans to the business within the business.
However, small businesses often don’t have enough available assets or credit history to qualify for the funds requested, or the business may operate with low margins or limited cash on-hand. All of these factors can work against the bank or lender agreeing to make the loan.
As a result, even when a loan is being made to the business, in many cases it’s a loan that has terms which pierce the corporate veil and involve the business owner personally. The most common of these is known as the Personal Guarantee, and in short, it makes you personally co-sign on the loan along with your business. In some cases, this can mean that equity in your house or savings set aside for a child’s college education can be at risk should the company default on the loan. In fact, most SBA loans today require a Personal Guarantee to be signed by each person who owns 20% or more of the business.
In addition to the Personal Guarantee, some lenders (especially alternative ones) apply an additional clause called a Confession of Judgment. Whereas a Personal Guarantee sets forth what you are personally liable for as a co-signer to your small business loan, a Confession of Judgment goes a step further and actually obligates you to waive your due process rights in the event of a default-related dispute and, in some extreme cases, enables a lender to access and remove funds from your business and personal bank accounts almost overnight. Many states restrict their use, but not all — and in fact their validity may have more to do with the state where the lender is based, rather than the state where your business is based.
Furthermore, some loans are packaged as “merchant cash advances” and not technically as “loans”, which may qualify them as unregulated financial instruments (the technical distinction between the two has to do with what, on paper, the lender is receiving in return for the funds being delivered, but in day-to-day reality it may not make any practical difference to the business).
These examples are critical to understand because they clarify that just because you opt for a business loan, does not mean that your personal finances or assets are protected. In many if not most cases, there may be one or more forms of personal liability associated with any small business loan, so it’s essential to stay alert and aware of these factors. It’s also a good time to point out that one advantage of personal loans is that, ironically, they may come with more legal protections than business ones. For example, Confessions of Judgment are outlawed at the federal level for most consumer loans, but business loans are regulated differently by each state.
So, personal loans can often be easier to apply for, require less paperwork to secure, may actually protect you to a higher degree and sometimes can be obtained as unsecured loans (i.e. not backed by collateral). Why apply for a business loan at all?
There are some significant reasons to consider a business loan. First, lending limits for business loans are often much higher than those for personal loans, and interest rates for approved business loans are often more competitive precisely because the process is more in-depth and therefore the lender has a higher confidence level about the borrower’s ability to repay. In addition, a business loan can be secured with company assets (for example, if you own the building your business is in or if your firm possesses trucks and equipment). And finally, a business loan helps establish a credit track record for the business, which is a significant strategic benefit over the long term.
What’s essential to understand is that lenders use many different methods, standards and practices to evaluate loans and package deals — and that each deal could be regulated under different laws and present different levels of risk to the business owner. It’s essential to evaluate each financing option clearly including not only the likelihood of approval and the interest rate, but also the loan terms, business or personal financial and legal obligations, and the nature of the process for addressing defaults or disagreements.
As a savvy small business owner, your best tool is knowledge. The more sophisticated and engaged you are as a loan shopper, the stronger your position will be as you pursue and select the best financing options to grow your business.