Can’t Get a Loan to Start Your Dream Business? Here are 6 Options for Raising Money

by Suzanne Kearns

6 min read

Even the smallest home-based businesses require some startup capital, but not having the credit to get a loan shouldn’t stop anyone from pursuing their dream. If you’ve put yours on hold due to a lack of funding, check out these six options.

Use Your Credit Cards

We’ve all heard stories of successful companies that were funded with the founder’s credit cards, but if you’re going to take this route, you’ll need to put some thought and planning into it. Here are some of the benefits of using this method.

> Unlike a loan-approval process, you’ll get the money fast.
> You can charge expenses as you go rather than borrowing the money all at once.
> If you have a solid payment history, you can try to negotiate a better rate or an increased credit line.
> You can transfer the balance to other zero- or low-interest credit cards regularly in order to get free funding for extended blocks of time.

But along with the benefits come some risks.

> If the business fails, you’ll be personally responsible for the debt.
> Because experienced lenders haven’t reviewed your business plan, there’s a greater chance you’ll invest in a business that isn’t sound.
> Depending on your credit score, your interest rates may be much higher than that of a bank loan.

You should always view credit cards as a temporary funding solution, and pay them off as soon as your business reaches its break-even point.

Borrow Against Your 401(k) Plan

If you have a 401(k) plan, you can withdraw the funds you need from it, but you’ll pay regular income taxes and, depending on your age, steep penalties for early withdrawal. Instead, you should take a personal loan from it to start your business. The IRS has very specific rules about how this should be done.

> You can typically borrow 50 percent of your retirement account funds, or $50,000, whichever is less.
> You must make quarterly payments, and the loan must be paid off within five years.
> You’ll pay interest on the loan of about 1 percent. The interest will go back into your 401(k) account.
> Your business must be incorporated.
> You’ll need to use the funds from your retirement plan to invest in corporate stock issued by your company; your new business will be owned and funded by your 401(k).
> You’ll need to roll the remainder of the funds into a new plan managed by your incorporated business.

Finally, it is possible to tap into your 401(k) plan to fund your startup by structuring your new business as a C corporation, issuing the stock, then transferring it to a new 401(k) plan. You’ll then exchange that for the cash you need for startup costs. The rules are complex, and the IRS suggests that you talk to a tax attorney or accountant for guidance.

Borrow Against Your Whole Life Insurance Policy

If you have a whole life insurance policy, it’s possible to borrow against it in order to fund your new business. (You can’t borrow against a term life insurance policy). Whole life policies are set up so that you pay more into them at the beginning of the policy, and the excess is known as the cash value of the policy. It’s this cash value, less the insurance company’s surrender charges, that you can borrow against. Although this is an easy way to fund a startup, there are some key points to consider.

> You don’t have to pay back the loan, but if you don’t, you reduce the amount your beneficiaries will receive.
> You’ll have to pay interest on the loan. Any unpaid interest will accrue as income and it will be added to the loan balance as compounded interest.
> If the loan amount plus interest exceeds the cash surrender value, you’ll be required to pay the difference. If you don’t, the policy can be canceled, and you’ll lose your life insurance coverage. If this happens, you’ll be taxed on the gains, which is the amount you received over the net premium cost.

If you are considering this type of loan, ask your insurance agent to run an in-force illustration, which will show you the impact the loan will have on your policy.

Take Out a Second Mortgage

If you have equity in your home, a second mortgage can be a low-cost way to fund your startup. Here are some important things to keep in mind when considering this form of funding.

> You’ll only be able to borrow against your home  equity.
> You must be current on your existing mortgage payments and have a good payment record with your lender to qualify.
> You’ll have to apply for the loan. As long as you can prove your ability to repay it, it will be easier to qualify for because the bank will use your home as collateral.
> You can take out a lump sum, or a home equity line of credit (HELOC) that allows you to take funds as you need them up to a predetermined amount. You’ll only pay interest on the amount you borrow.
> You may have to pay an annual fee.
> You won’t have to begin repaying the loan until after the draw period, which is typically about 10 years.
> Your interest rate will likely be adjustable, but you can convert to a fixed rate after the draw period.
> If you default on the loan, you could lose your home.

Borrow From Friends and Family

Thirty-eight percent of startups are funded by friends and family, and the average investment is $23,000. But if you’re going to involve your friends and family in your business venture, there are a few things you should do to avoid damaging your relationships.

> Decide whether you want loans, investors, or partners. If you simply want a loan, then you will remain in control of the business and only have an obligation to repay the loan. Investors will reap a return on their investment and may want some input into business operations. Partners will be fully active in the business and make decisions alongside you. It’s important that you’re clear about what you want before you approach someone for funding.
> Be clear about the terms. If you’re offering to pay interest, make sure you agree on the rate. Be upfront about the risks, and the amount of time it will take you to repay the loan.
> Outline your business plan just as you would to any lender. Talk about your idea and how you plan to set up and grow the business.
> Get help arranging it. Peer-to-peer (P2P) lending sites like TrustLeaf will help arrange a business loan between you and your lenders. They will prepare agreements between the parties and help facilitate the payments.

Find Alternative Financing

Many startups have turned to alternative lenders to get the funding they need. Here are some options.

> If you need a loan that is less than $35,000, a microloan might be right for you. Interest rates vary and the typical repayment period is six years. If your credit history has some marks against it, you should check into P2P sites like Lending Club and Prosper.com. If your credit is solid, the Small Business Administration provides a list of lenders [PDF] that offer better rates.
> If your credit history is good, but not good enough for a traditional loan, a midprime lender may be the answer. Funding Circle and Fundation are two examples of lenders that work with these types of borrowers.

If you’ve been putting your startup plans on hold for lack of funding, why not consider one of these options and begin building the business you’ve been dreaming of?

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