When it comes to business loans vs. personal loans, many borrowers take the same approach. A loan is a loan, right? Business loans and personal loans are actually quite different and should be approached with different criteria, but it makes sense that most people think of them as the same. After all, most people have much more experience with personal loans than they do with business loans. Home mortgages are much more likely to be the subject of Thanksgiving dinner conversation than a merchant cash advance, for example.
While understanding personal loans can help you decipher the financial jargon that often accompanies a business loan, approaching business financing the same way you’d approach a personal loan often limits your flexibility and return on investment.
We’ll run through some of the shared components between business and personal loans to examine the different approaches borrowers should take to each loan type.
The Return on Investment
Business loans tend to have much larger returns compared to the return on a personal loan.
Personal Loans: The Loan Principal
When you take out a personal loan, you expect to repay the loan principal. You might take out a loan to finance a home purchase or remodel. You might take out a loan to consolidate debt. You might use a personal loan for medical bills. In all of these cases, the loan helps you to pay for something with a fixed cost by breaking it into affordable payments over a longer period. If there is an opportunity to make a profit—as is the case with a home purchase or remodel—it tends to be a longer-term play, and profits tend to be a smaller percentage of the capital spent.
Business Insider: Increased Sales and Profits
The uses for business loans vary much more wildly, and so, therefore, do the returns. Generally speaking, the return on investment for a business loan is determined by sales and profits. Sometimes that means that a loan is used as a safety net until your company receives payments it’s owed, as is the case with accounts receivable financing.
With business loans, borrowers can often benefit from a shorter loan term vs. the best-practice of looking for the longest term for personal loans.
Personal Loans: Look for Longer Terms
As a general rule, the best loan term for a personal loan is the longest one you can find. It gives you the most time to repay and reduces monthly payment costs.
Business Loans: Shorter Loan Terms Are Often an Asset
Because a business generates returns on a loan based on investment and profit, a small business can usually repay a loan much quicker than an individual. Say you need financing to make a large inventory order. Once you have that inventory, you can sell the product and turn it into profit. That process can be as quick as a few months. But if your loan term is 2 years, it may prevent you from taking advantage of other opportunities over the life of the loan.
Most lenders will require that your loan is repaid before you can take out another loan. They make this requirement to prevent borrowers from taking out additional loans without any intention of repaying the original loan. This limitation can mean that if you come across another great opportunity that requires financing 6 months into your 2-year loan term, you may not be able to take it.
Shorter loan terms often give business owners more flexibility and agility. When you’re comparing loans, consider how quickly you think you’ll be able to repay. Opting for a shorter loan term may actually put your business in a better position down the line.
How to Determine What You Can Afford
What you can afford in a personal loan is determined by your income vs. a business loan, where the loan funds may change what you’re able to afford.
Personal Loans: Cost of Capital Limited by Fixed Income
Most personal expenses are fixed: the cost of your home, utilities, groceries, gas. These all fall into your monthly budget, with some wiggle room for entertainment and discretionary spending. Personal income tends to be fixed, too. People generally receive the same salary payments month over month—with some wiggle room for commissions or months with more hours. You know the baseline that you can repay each month, and your ability to handle the cost of capital is calculated from there.
Business Loans: Higher Profit Margins Can Make a Higher Cost of Capital Worth It
Businesses operate on profit, not income. As such, a business can often handle a higher cost of capital than an individual can. To determine what cost of capital the business can handle, ask yourself what the loan will allow your business to do. If a loan allows you to cover employee-related expenses, you’ll want to ask yourself, what can your company generate with that labor? Purchasing a specialized canning machine may allow you to secure a new account.
What profit would your company stand to gain if you had more working capital? By asking that, you can also see what you stand to lose if you don’t have the capital to pay for it. A loan with a 20% interest rate may actually serve you better than waiting for a 7% loan if that prevents you from taking advantage of current opportunities.
How to Evaluate a Business Loan
Don’t use the principles of personal loans and personal finance to weigh the pros and cons of a business loan offer. When looking for a business loan, you may choose a loan with a higher rate or shorter term than you would with a personal loan. Instead, ask yourself the following questions:
- What is the potential ROI on the loan?
- How quickly do you think your business will be able to repay it?
- If you go without financing, will it prevent you from taking advantage of X opportunity?
If you’re still unsure, talk to a small business loan expert.