Finance Your Own Business - Garrett Sutton

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you’re thinking of taking out one of these loans, one of the hardest things to do it so put your optimism aside for a moment. Most entrepreneurs are risk-takers; if they weren’t, they’d never venture out on their own. But you need to think about what will happen if it takes longer to get off the ground than you planned. Will you be able to repay the loan? What happens if you can’t?

      How Long Is Your Runway?

      Emily Chase Smith is an attorney and coach who works with entrepreneurs. She says: “Every business takes twice as much time and twice as much money as you think it will, and we call that your runway. You want to extend your runway as far as you possibly can. Sometimes as small business owners, we just see the vision so clearly, so we go for the big vision and we don’t have a plan for how we’re going to get there. So we might go out and rent a giant office because that’s our vision. We’re going to have this fantastic law firm or we’re going to have this great retail space, to satisfy our vision as opposed to taking the realistic steps to get there. But then we run out of runway. We run out of money and run out of time. Perhaps (if we took it more slowly) we could have had a fantastic business.”

      Reverse Mortgages

      If you are 62 years or older and you have equity in your home, you may want to consider a reverse mortgage (officially known as a home equity conversion mortgage) instead of a home equity loan.

      A reverse mortgage is a federally-insured mortgage, only available to homeowners 62 years or older. You get the proceeds of the loan in one of three ways; as a lump sum, in monthly installments or as you need it (a line of credit). You don’t make mortgage payments, but you are required to pay your taxes and homeowners insurance. And if you get a reverse mortgage on a property that already has a mortgage, the existing loan will be paid off and a new loan put in place.

      When you sell your home, or if you die before then, the reverse mortgage is paid off—including interest and fees that have accrued on the loan—and any equity left in the home goes to your heirs or estate. If your home’s value has dropped, however, and there is not enough equity to pay off the reverse mortgage, then the lender takes the loss regardless of other assets you may leave behind.

      The advantage of this type of mortgage for an entrepreneur is clear: If it takes you longer to generate cash flow than expected, you won’t be scrambling to make payments on your mortgage or a home equity loan.

      In the past, lenders didn’t even look at borrower’s credit reports, making these loans especially attractive to those with past credit problems. But due to losses by the FHA, a “financial review” that includes a credit check is required as of March 2015. That doesn’t mean you can’t get a reverse mortgage if you have bad credit, but it does mean you may need to provide an explanation for how you plan to use funds to pay back currently delinquent debts. Still, a reverse mortgage isn’t reported on traditional credit reports, so taking one out won’t hurt the business owner’s credit history.

      These loans can get expensive, and some older people have been sold loans that weren’t appropriate for them. Of course, there is always the risk of sinking your home equity into a business venture that might fail. You can lose your equity and have nothing to show for it. As a result of past abuses in this industry, you are required to get mandatory counseling from a HUD-approved counselor before you can get one of these loans.

      On the other hand, unlike a home equity loan, you won’t be kicked out of your house because you can’t make your loan payments. You must keep up with your property taxes and required assessments such as homeowner association dues, though, or you could lose your home. The lender will also require you to keep a minimum amount of homeowner insurance in force to protect the lender in case of a fire or other catastrophe. You will have to be able to document that you can afford to continue to make your insurance and tax payments in order to get one of these loans.

      Personal Bank Loans

      In the Inc. 500 survey, 13% of respondents said they used personal bank loans to fund their businesses. That makes sense, as it can be hard to get a business loan for a brand-new venture. However, personal loans also carry a tremendous about of risk.

      Getting a personal loan will require a personal credit score strong enough to help you qualify for the loan, and a large and steady enough income to support the payments. If you are considering a personal loan for business financing, ask potential lenders the following questions:

      Do you have a minimum credit score requirement? If the lender will tell you what the minimum credit score needed is in order to qualify, you’ll at least know whether you are in the ballpark. Understand, though, that you don’t have a single credit score; you have many. There is a good chance that if you checked your credit scores, you won’t have seen the same exact credit score the lender is using. That’s true even if you order your credit score from the same bureau the lender uses. Lenders may use custom scores, or scores that aren’t generally available to consumers.

      If you are turned down for a personal loan, the lender is required to disclose your actual credit score, based on the credit scoring model they used, and give you information about how to order a free copy of your credit report from the reporting agency that supplied your report. Take advantage of this opportunity to learn more about your credit score for free.

      Is there a maximum debt-to-income ratio you’ll accept? A debt-to-income ratio typically compares the borrower’s gross (before tax) monthly income to monthly debt payments. A typical requirement for many lenders is that debt payments excluding any mortgage payment don’t exceed 28 – 30% of gross income, and that total debt payments including a mortgage total no more than 38 – 40% of gross income. Be sure to count the new loan when calculating your debt-to-income ratio.

      What are my payment options? Will you have a fixed monthly payment, or will you be able to make minimum monthly payments if cash flow is tight?

      Is this a revolving or installment loan? With a revolving loan, you can borrow up to a certain limit (your credit line), while an installment loan will allow you to borrow a specific amount of money and pay it back over a specific period of time. These two types of loans are very different in terms of how they affect your personal credit scores.

      Let’s say you need a $10,000 loan to start your business. If you get a revolving line of credit and use $8000 right away, you are using 80% of your available credit. In credit scoring terms, that ratio of available credit to balance is called the “utilization” or “debt usage” ratio. And when it comes to your credit scores, that high utilization ratio is likely to hurt your credit scores. There’s no ideal utilization ratio, but consumers with the highest credit scores tend to use about 10% of their available credit.

      But if you get that same loan as an installment loan, then it will be viewed differently. If your loan is reported as “installment” rather than “revolving” credit, the amount of debt is part of the credit score calculation, but utilization is less likely to be a problem. You can shop for a personal loan to start your business by finding out what your current bank or credit union has to offer. One type of personal loan that is growing in popularity is the peer to peer, or P2P loan.

      Peer to Peer Loans

      The original premise behind peer to peer or “P2P” loans was to cut out the middleman—banks—and to match individuals who have money to lend (lenders/investors) with individuals who need to borrow money. The premise was that lender/investors can earn a better return on their money by lending directly. In addition, these companies sold lenders on the idea that they could spread out their risk by lending small amounts of money to many different borrowers. LendingClub.com and Prosper.com are two of the earliest major players in this space, and they have both been very successful with this model. So successful in fact, that it’s no longer just individual lenders providing the funds for these loans. Large investors such as pension funds and institutional investors are major lenders for these platforms now, too.

      Borrowers who qualify typically get a loan with a fixed interest rate and fixed monthly payments. Often these loans are used by individuals who are starting, or growing a business. If you are looking for

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