Last updated Feb. 26, 2024 by Jessica Green
Most financial experts advise that borrowing money to start a business is a bad idea. If you’re wondering why this is, this article explains.
Launching a new business requires tons of planning. Additionally, you must be confident in the business’s ability to generate profits. But regardless of your confidence in the business, taking a startup loan is often advised against.
Here are twelve reasons why borrowing money to start a business is a bad idea. This article also provides a guide on how to get a startup loan.
12 Reasons Why Borrowing Money To Start A Business Is A BAD Idea
1. Strict Eligibility Requirements
Business loans are not like your typical personal loan. The requirements for qualification are different.
Anyone can take out a personal loan within minutes or hours. However, a startup or business loan requires days and weeks for approval. To get approved for a business, here are some of the requirements:
A. You must have a detailed business plan. If you’re applying for a loan from a bank or credit union, you’ll be required to provide detailed information on the business idea and how you intend to generate profits.
Most lenders also impose strict requirements on startups. For example, your startup may be required to generate between $250,000 to $300,000 annually. If your business plan does not align with the requirements, a loan may not be given to you.
B. Collateral
C. Repayment Terms
D. Business Credit Score
E. Loan Proposal
F. Bank Statement
G. Business Licence
2. Interest Rates and Payment
If you’re borrowing money to start a business, you’ll need to pay interest on the loan after a certain period. The interest you pay depends on the interest rates of the lender – Interest rates are a percentage of the loan principal that is charged to a borrower.
As a startup, interest payment can eat into your profits and prevent you from reporting expected profits. And as you know, startups are more prone to failure. So as the owner of a new business struggling to find its footing, interest payment can cause a financial strain to you.
If you don’t have the right financial knowledge and ability, your business could fail. Thus, interest payment obligation is one of the reasons why borrowing to start a business is a bad idea.
Another Interesting Article: Best Personal Loans with Low Interest
3. False Sense of Security
One of the reasons why borrowing to start a business is a bad idea is due to the false sense of security it gives to borrowers.
When you secure a business loan, you may begin to feel like you have everything sorted out. Everything becomes sunshine and rainbow until you realize the deceptive nature of loans. With every loan comes obligations and interest payments. And if you can’t keep up with these obligations, your business can fall into a precarious situation.
Additionally, starting a business with a loan can create dependency, a cycle of debt, and financial stress.
4. Higher Risks and Risk of Default
The success of a business is unpredictable. If the market for your business fluctuates, you could be at risk of experiencing business failure. And if your business happens to fail, you’ll be tasked with paying off the debts.
In another case, if your startup does not generate the needed revenue to cover interest payments and other costs, you’ll be at high risk of defaulting on the loan.
Defaulting on a business loan comes with great consequences. Some of which include the following:
- Legal actions: A lender can decide to take legal action against you.
- Bankruptcy filling: In most loan default cases, you may be required to seek invention by filing for bankruptcy.
- Damaged credit score: Defaulting on a business loan impairs your credit score and makes you ineligible for other loans.
- Loss of asset: If you place any of your properties as a guarantee, it could be seized by the lender.
5. More Expensive
Borrowing to start a business may give you quick access to funds, but in the long run, it is expensive.
Interest payments, loan application fees, credit check and report fees, origination fees, admin fees, monthly/annual fees, overdue fees, and prepayment penalties are some of the fees associated with a business loan. All these fees eat into your revenue and leave you with a low disposable income.
Another point to note is that credit and financial institutions view startup businesses as high-risk investments. Thus, the loans they provide come with a higher interest rate.
6. Requires a Guarantee or Collateral
There are two types of business loans – secured and unsecured loans. A secured loan is a loan that requires you to provide any of your assets as collateral in the case where you default on a loan. An unsecured loan, on the other hand, is a loan that is approved based on your creditworthiness. Most lenders who offer unsecured loans may request a personal guarantee.
A personal guarantee is a legal document that states your promise to take responsibility for a loan in the case where your business fails to repay the loan. While a collateral is an asset that acts as a security for a loan.
Taking a secured or unsecured loan to start a business is generally a bad idea. You stand a chance to lose your assets if you default on the loan. For an unsecured loan, legal actions can be taken against you, and you may be forced to give up your personal property.
7. Difficult To Qualify
Borrowing to start a business may sound easy, but in reality, it isn’t a simple task.
According to the International Factoring Association, the approval rate of business loans by banks, credit unions, and alternative lenders is 21.2%, 20.2%, and 27.6% respectively. In other words, if you’re applying for a loan from a bank, you have a 21.2% chance of being approved.
So even if you have the idea of borrowing from a bank, you may not secure the loan, and the loan terms may be unfavorable to you.
Some factors that are considered by lenders when offering loans include the following. These factors can decide your rate of approval.
- Cash-flow and income
- Business plan
- Credit Score
- Collateral
- Loan Amount
8. Required To Give Up Equity/Loss Of Control
There are tons of ways to secure funds for your new business. If you’re taking out a business loan from the bank, you’ll be able to retain control of your business. However, if you intend to secure a loan from equity investors, be prepared to give up some stakes in your business.
Equity investment is a way to secure finances for business ideas. It is when an investor funds a business by purchasing its shares. Through the purchase of shares, the investor gains some control over your business.
If you’re borrowing to fund your business through this method, you’ll lack the power to make vital decisions concerning your business.
9. Potential Debts Burden
Being trapped in debt is one of the things you should never experience as a business person. Debt limits you and gives you a bad record that prevents further financing opportunities.
So as a business person, it is important to avoid situations that could lead to owing debts – this is one of the reasons why borrowing to start a business is a bad idea.
Every business comes with uncertainty and risks. Regardless of how strategic and feasible your business plans are, there is still the possibility of encountering events that could lead to failure. And if the business happens to fail, you’ll end up with a potential debt burden.
Another Interesting Article: 8 Debt Payoff Apps
10. Pressure To Perform
To get approval for a business loan, there are certain loan terms and conditions you need to agree with. One of which is the minimum revenue qualification requirement.
Most lenders set a minimum revenue amount. In other words, your business plan must provide proof that you can generate a certain minimum amount in a month or year. Once you agree with the requirements of the lender, you’ll become pressured to perform efficiently.
The pressure to perform can lead to bad decisions that are not in the best long-term interest of your business.
11. Limited Flexibility
Another reason why borrowing to start a business is a bad idea is due to the limited flexibility it brings to you. Once you take out a business loan, you’ll be obligated to pay back the loan. The repayment period may take months or years, depending on your agreement with the lender.
During the repayment period, you may be restricted from taking out other types of loans that could grow your business. In addition, you’ll be unable to weather unexpected finances or invest in growth opportunities.
12. Stress and Anxiety
Most people ignore the mental pressure that comes with borrowing money to start a business. If you’re dealing with anxiety, it is recommended to avoid anything that triggers it.
Once you take out a business loan, you’ll fall under pressure to repay the loan. This pressure can lead to a high level of stress and anxiety.
Alternatives to Startup Business Loans
If you’re having second thoughts on borrowing from a bank or credit institution, there are alternatives to consider. These alternatives come with fewer risks.
1. Crowdfunding
If you’re starting a new business, one of the best ways to raise capital is by crowdfunding – this is the process of raising money from a large number of people.
Most people run crowdfunding campaigns online. If you have a large network of friends, you’re more likely to run a successful campaign.
2. Venture Capital
Venture capital is one of the best ways to finance a startup business. It is when investors invest capital in a business in exchange for an ownership interest.
If you intend to secure capital through this method, be prepared to share control of your business.
3. SBA Loans
A Small Business Administration (SBA) loan is a government-backed loan available to US residents. It provides loans with affordable interest rates to help startups and small business owners.
If your startup does not qualify for a loan from the bank or other credit institutions, there’s a high chance of receiving approval from SBA.
4. Bootstrapping
Bootstrapping means using your personal capital and savings to finance a new business. Rather than take loans, you can rely on your finances.
One advantage of bootstrapping is that you’re free from the potential debt burden.
5. Grants
Grants do not come with an interest rate. So if you require capital for your business, consider applying for grants.
Most federal, state, and local governments offer grants. Find out which works for you.
How To Get A Startup Loan
The approval rate for a startup loan is very low. In other words, your chances of securing a loan for your new business are slim. To help you get around this, here’s a simple guide on how to get a startup loan.
1. Be Specific On How Much Funds You Need
If you request too much funds for your business, you may end up struggling to pay it off. In addition, requesting a large amount can result in rejection.
2. Decide On The Type Of Loan To Apply For
There are different types of business loans, some of which include bank loans, SBA loans, venture capital, online loans, equipment financing, business lines of credit, microloans, and commercial real estate loans.
3. Know Your Eligibility Status and Credit Score
Your business and personal credit score is one of the factors that determine your approval rate.
Most lenders also request for personal guarantee, your years of experience in business, debt obligations, and expected annual revenue.
4. Research and Compare Lenders
If you’re eligible for any type of business loan, research and compare the requirements for loans offered by lenders. Most lenders offer high-interest rates and unfavorable loan terms.
To be on the safe side, here are some factors to compare:
- Fees and other costs associated with a business loan
- Annual Percentage Rates (APRs)
- Lender reputation
5. Submit Your Application
Once you decide on a lender, prepare your business plan and other documents that could aid your approval rate. Know the right application process and apply.
Conclusion
Borrowing to start a business is generally not a good idea. However, if you’re confident in the leadership, marketing, and management of your business, go ahead and take out the loan.
Frequently Asked Questions On Borrowing Money
What Is The Biggest Risk Of Borrowing Money?
One of the biggest risks of borrowing money is the risk of default. If you default on a loan, your credit score and reputation drops. This limits your future financing opportunities.
Can a Startup Get A Business Loan?
Yes! Startups can get access to a business loan. Some of the best types of loans for a startup include SBA loans, term loans, Microloans, Invoice factoring, and invoice financing.
How Do Businesses Borrow Money?
A business can borrow money by sending loan applications to banks, credit unions, or investors.
