The process of starting your own business involves a steep learning curve. As a new entrepreneur, you’ll have to learn how to be your own boss and manage your business’s finances, including filing your tax returns, using a credit note and creating financial reports.
Another huge part of managing your business’s finances is being able to secure a loan to get the investment boost you need. If you want your start-up to reach its full growth potential, you’ll need this funding to get past the initial phases of development and have enough cash to sustain yourself. In fact, 79% of failed small businesses find themselves in this situation due to starting out with too little money.
Securing a loan from a bank is one of the most common ways to get funding to start a business. However, there are many risks involved in getting a business loan, and you should be fully aware of these before you take the plunge and decide to get one. Here are the main risks you should consider.
Defaulting on a loan means that you’ve missed one or more loan payments for a certain amount of time. The exact circumstances under which your loan enters default will depend on the terms of your initial loan agreement, but if you’re struggling to meet your regular repayments, this certainly isn’t a good sign for your business.
But what are the consequences of defaulting on a loan? In short, this will put your business into even more financial hardship. Defaulting on a loan shows that your business is not a reliable borrower, which can damage your credit score, increase the interest rates on any new debt and make it harder for you to secure further loans in the future. In severe cases, you could end up in court if you fail to repay your loan.
Defaulting on a loan is always a potential risk. Even if you’re doing well financially when you initially secure the loan, bad luck or failed business ventures could mean that you’re left with insufficient cash to repay the loan further down the line. Therefore, you should always think very carefully about your financial situation before you get a loan to reduce your chances of defaulting.
A common issue that small and new businesses face when trying to secure a loan is that they often don’t have an established financial history to show that they’re capable of making repayments. In this case, the business owner will usually have to use their own personal credit to guarantee the loan, which means they’ll be personally liable for repaying the loan if the business defaults.
Naturally, the issue with this is that you’ll have to repay the loan if something goes wrong with your business. If you secure a pretty substantial business loan, this could be something you’re unable to pay if the debt passes on to you, so you need to be aware of this risk before signing a personal guarantee for a loan.
Another consequence of failing to repay a loan that you’re now personally liable for is that this will negatively impact your credit score. So, instead of this only affecting your business, this will now be visible on your credit history, making it harder for you to secure personal loans in the future (e.g., mortgages and car loans).
Having a low credit score can be very damaging to your finances, but there are ways to slowly improve it. For example, you could keep your credit usage low and limit your applications for new loans or credit cards, as multiple applications can show lenders that you’re in financial difficulty.
Rather than signing a personal guarantee to secure a business loan, you could opt for a collateral loan instead. With this type of loan, you’ll be asked to guarantee it with your assets, such as land, equipment, or real estate.
The risk with a collateral loan is that if you can’t pay, the bank or loan company will seize these assets to cover the loan. If you offer necessary land and equipment as collateral, this could have a huge impact on your business and potentially make it very difficult to continue trading. So, although you won’t be personally liable and your credit score won’t be affected, you’ll still have to deal with a different set of risks by choosing a collateral loan.
Too Much Debt
Taking on too much debt at once could spell disaster for your business. This may sound obvious, but it’s common for businesses to take on additional loans while still paying off an earlier loan.
Often, businesses will secure multiple loans if they require a lot of funding, but if they can’t start turning a profit as intended, this could backfire catastrophically. In addition, continuously applying for loans could show lenders that you’re struggling financially, which will damage your ability to secure loans in the future.
To avoid this issue, it’s crucial to not take on additional loans if you’re already struggling to make repayments on a current loan. Before you apply for a loan, you should have a clear plan of how you’re going to afford the repayments and what you’ll do if you encounter a string of bad luck.
Finally, you should pay attention to interest rates if you want to avoid sky-high monthly repayments. The amount of interest you pay will depend on your loan, but due to interest rate fluctuations, you could find yourself paying more than you intended.
With a variable-rate loan, the main risk is that interest rates could rise and cause your loan repayments to increase. The amount of interest you pay can change throughout the term of your loan if you opt for a variable-rate loan, which means you’re not protected against rising interest rates.
However, a fixed-rate loan isn’t exactly risk-free. Since the amount of interest you pay will be fixed for the term of your loan, you’ll be protected against interest rate rises, but if interest rates fall instead, you’ll be locked into paying a higher rate of interest for a certain period of time.
Therefore, if you want to ensure you’re not paying too much interest on your loan, you need to study financial trends to figure out if a variable-rate loan or fixed-rate loan is better for your business. As always, being aware of these trends and your own financial situation is essential for mitigating the risks of securing a business loan.