Almost every new business requires some sort of outside funding to get off the ground. If you’ve ever launched a business, then you know how difficult it can be to secure that funding. Young business owners in particular may struggle to get loans without a sufficient credit history. As a result, many entrepreneurs are forced to turn to their family and friends for help.
While borrowing from people you know allows you to launch faster with fewer hurdles, the process is not without its downsides. Below are some of the many pros and cons involved in accepting loans from friends and family. Do your research so you can make the best decision regarding both your business and your future relationships with loved ones.
Here are some of the advantages of turning to friends or family members for your next business loan:
Young entrepreneurs and those with poor credit may struggle to secure a loan through traditional means. According to a recent university study, just 39% of small businesses managed to secure funding through a bank, with the most common causes of rejection being insufficient debt load, cash flow and collateral.
One of the benefits of borrowing from loved ones is that you don’t have to jump through the same financial hurdles to be approved. Because they are eager to help you achieve your goals, friends and relatives will often lend to you in cases where banks would not.
Additionally, private lending tends to allow for more flexible repayment schedules. For example, you can set up a grace period that allows you to halt payments while your business is getting off the ground. As an added benefit, borrowers may have the option of ceasing payments if their business hits a rough patch, something that traditional lenders will rarely permit.
Lower Interest Rates
As such, one of the benefits of borrowing from friends and family is that you can typically land a lower rate. Not only does this reduce your overall debt level—helping to boost long-term credit for your business—but it also enables you to invest more of your hard-earned cash back into the company. Investing money back into your business will help you grow faster and ultimately pay off loans quicker.
Of course, borrowers aren’t the only ones who can benefit from a private lending arrangement. The savvy lender can often earn money by investing in your business, provided he or she does sufficient research into the potential benefits and pitfalls of investing. Along with the satisfaction of helping a friend or family member in need, investors may enjoy being part of the business-formation process while earning returns similar to those provided by a savings account or CD.
Despite the many benefits to investors and lenders, personal loan arrangements can be complex. Here are some of the social and financial ramifications of accepting a loan from a friend or relative:
Lack of Clarity
One of the advantages of personal loans is that they don’t require the same legal documentation as those provided by a bank or other lender. However, the lack of term clarity can be detrimental if borrowers and lenders have different expectations.
For example, lenders may assume their financial investment gives them a stake in the company or a voice in daily operations. On the other hand, borrowers may believe that it’s okay to miss the occasional payment since the lender is a friend. By carefully documenting all terms and conditions in advance, the parties involved can avoid misunderstandings while ensuring their personal relationships remain unblemished throughout the length of the loan.
For best results, borrowers should arrange for a business attorney to draw up a promissory note or similar document that outlines interest rates and payment terms, including penalties and late fees. Additionally, the loan document should stipulate what will happen if your business proves unsuccessful. Ensure that the lender knows all the possible risks and rewards of investing in advance to avoid disagreements down the line.
In their eagerness to help a friend or loved one in need, lenders may neglect to consider the effect a loan will have on their tax liability. Not only does insufficient loan documentation open the involved parties up to IRS scrutiny, but it may also lead to a contribution being categorized as a gift instead of a loan.
To protect their interests, both borrowers and lenders must follow the steps traditionally taken by a bank or credit union when setting up a loan. Along with a signed promissory note, your loan documentation should feature a detailed repayment schedule that includes interest to ensure you meet all IRS guidelines for private lending.
Of course, accepting loans from loved ones isn’t just problematic from a legal perspective. Mixing business and pleasure can also complicate routine social interactions.
One of the disadvantages of owing money to loved ones is that it may open up unwanted dialogue about your spending habits. Whereas a bank won’t tell you to stop going out to dinner or discourage you from buying a new car, lenders who are also friends or family may criticize you for spending money on extravagances when you have yet to repay your debt. Setting clear payment terms and sticking to them can help borrowers avoid these uncomfortable moments, keeping social interactions pleasant throughout the length of the loan.
Accepting a loan from a friend or family member allows you to avoid banks and lenders while securing a lower interest rate. However, failing to set up clear and defined terms for repayment could make social interactions highly unpleasant. For best results, take time to create a solid repayment plan with a modest yet valid interest rate. Doing this will help ensure a positive outcome for all involved.
For more lending options, see our article on the different types of business loans.