Business and personal loans both provide you with a lump sum that you repay in monthly installments. However, while there’s some significant overlap in their functionalities, they’re not interchangeable.
If you’re looking to borrow, here’s everything you need to know about business loans versus personal loans in order to determine which makes the most sense in your situation.
What is the Difference Between a Business Loan and a Personal Loan?
Business and personal loans share a fundamental structure, but there are notable differences between them, including their allowable uses, terms, and qualification requirements. Here’s a detailed explanation of the primary things to consider.
How Can the Loans Be Used?
In general, you have to use business loans for business purposes. That includes purchasing company equipment, generating working capital, covering startup costs, and funding payroll.
That means you won’t be able to use a business loan for anything personal. For example, you can’t use one to consolidate your personal and business credit card debt or improve your personal residence.
Conversely, personal loans have more flexibility, and you can often use their funds for either business or personal pursuits. That could be anything from purchasing supplies for your new coffee shop franchise to financing your honeymoon in Hawaii.
However, the restrictions on your use of the funds can vary between lenders, so double-check before you apply. For example, personal loans often forbid you from using the proceeds to pay for college or to refinance a student loan.
If a lender prohibits any particular use of funds, don’t try to do it behind their back. If you violate your loan agreement, they could demand that you pay your principal and interest all at once.
Tax Deduction
If you use a term loan for business purposes, the Internal Revenue Service (IRS) lets you deduct the interest portion of your monthly payments from your company’s taxable income.
Because you can’t use business loans for anything else, their interest is almost always deductible.
However, the interest you pay on personal loans may or may not be deductible depending on how you spend your funds. In most cases, you can only take a deduction for the portion of the interest that corresponds with your business usage.
For example, say you receive a personal loan for $10,000. You spend $7,500 of the proceeds on improvements to your personal residence, then use the remaining $2,500 for marketing your side hustle. Only the interest on the $2,500 would be tax-deductible.
Try to avoid splitting your loan proceeds between deductible and non-deductible uses. Calculating the allowable interest deduction when you’ve mixed the two can be complicated and time-consuming.
Note that if you itemize rather than take the standard deduction, you may be able to deduct personal loan interest in a couple of other situations. For example, interest on money invested in taxable investments or qualified education expenses may qualify.
If you think any of those tax deductions apply to you, it’s a good idea to consult a Certified Public Accountant (CPA). They can help you minimize your tax liability without accidentally breaking any rules.
Loan Term
Another significant difference between business loans and personal loans is the length of time you usually have to pay them back. In general, business accounts have much longer repayment terms than personal ones.
You can expect business loan terms to be measured in years or even decades if their purpose is to finance real estate purchases. Personal loans may only last months, and you’ll struggle to get one that gives you more than seven years to pay.
For example, Small Business Administration (SBA) loan terms are 25 years for real estate financing and 10 years for equipment, working capital, and inventory loans. Meanwhile, Wells Fargo offers customizable loans that range from 12 to 84 months.
Though it depends on the amount you borrow, the difference in repayment term lengths means that small business loans may have smaller monthly payments than equivalent personal loans.
For example, if you borrow $20,000 at 6% interest and pay it back over four years, your monthly payment would be $470. However, if you paid it back over seven years, your monthly payment would be $292, even though your interest rate didn’t change.
Then again, longer repayment terms and smaller monthly payments generally lead to higher total interest expenses. In the example above, you’d incur $4,542 in interest with a seven-year loan but just $2,546 with the four-year term.
Loan Amount
One of the reasons business loans often have longer repayment terms than personal loans is that they also tend to have higher loan amounts. Generally, the more you owe, the longer it’ll take you to pay back the amount.
Because companies often have much more significant expenses than consumers, their loan amounts can be hundreds of thousands of dollars, if not millions. For example, businesses can qualify for up to $5 million with a 7(a) SBA loan.
In contrast, personal loans tend to be much smaller. For example, Wells Fargo offers personal loans from $3,000 to $100,000. However, TransUnion found that the actual average for new unsecured personal loans among consumers is just $7,104.
Of course, there’s a lot of overlap between the two ranges. If you want to borrow between $5,000 and $100,000, either loan might suit your needs. Anything less, and you’ll likely need a personal loan. Anything more, you should target a business loan.
Collateral Requirements
Last but not least, there are significant differences between the collateral requirements you’ll encounter when applying for a small business loan versus a personal loan. In general, business loans are much more demanding.
Requirements vary between lenders, but you’ll often have to pledge assets like property, equipment, accounts receivable, or inventory. If you’re using your business line of credit to finance a capital expenditure, the underlying asset will usually be your collateral.
Depending on your business credit, lenders may also require that you sign a personal guarantee for your business loan. If you ever default, they’d be able to collect by seizing personal assets.
Personal loans, on the other hand, don’t always require collateral. It depends primarily on your creditworthiness. If you have good credit, you’ll probably be able to get an unsecured loan. If not, you may need to apply for a secured loan to qualify.
Collateral for a personal loan is usually cash, a vehicle, or your home. If it’s the latter two, the lender often places a lien against your property during the life of the loan and then removes it once you pay off your balance.
Pros of a Business Loan
As you might expect, business loans are ideally suited for business purposes like purchasing new equipment or generating working capital. They have several advantages over personal loans in this area, including:
- Higher loan amounts: Qualified companies can potentially access millions of dollars through business loans. Meanwhile, personal loan amounts rarely exceed $100,000.
- Longer repayment terms: Business loans can last for years or decades, while personal loan terms are usually measured in months.
- Lower interest rates: Though it depends on the lender and your credit scores, business loans often cost less than personal loans. For example, traditional bank loans average 2% to 13%, but your personal loan interest rate could be as high as 36%.
In addition to their more favorable terms, business loans may also let you avoid signing a personal guarantee. However, to do so, you’ll need to establish your company as an independent entity and build good business credit scores.
Cons of a Business Loan
Business loans are one of the best ways to meet your small business financing needs, but they’re not perfect and may not be the best choice in some situations. These are the primary disadvantages to consider:
- High qualification requirements: The most significant problem with business loans is that they’re hard to qualify for, especially for young companies. You’ll need to be in business for a few years, have good business credit scores, and show sufficient annual revenues to qualify for an account.
- Significant potential downside: You usually need to supply substantial collateral to qualify for a business loan. If you default, the lender will seize your pledged assets. If you sign a personal guarantee, they may also come after your personal assets.
The bottom line is that business loans are the best way for well-established companies to finance business expenses or expenditures. However, outside of that situation, they’re not very useful. New businesses can’t use them and neither can consumers.
Pros of a Personal Loan
Business loans tend to have better terms on average, but personal loans still have their place. These are the most significant reasons to consider taking out a personal loan:
- Accessibility: Typically, all you need to qualify for a personal loan is a good personal credit score. Even if your credit is only fair, you’ll still probably be able to get an account, though your terms will be less favorable.
- Unsecured options: Business loans typically require that you pledge assets like property or equipment as collateral, but many personal loans don’t. However, you can use secured loans to overcome bad credit.
- Flexibility: You can often use personal loan funds for whatever you want, including business and personal expenses. Just confirm that there are no restrictions with your lender first.
In general, personal loans make the most sense when you’re financing personal expenses. Alternatively, they can be a viable financing option for businesses that can’t qualify for a traditional business loan.
Cons of a Personal Loan
Personal loans are generally easier to qualify for than business loans, and you can use them in many more situations. However, they have their flaws too, and you have to be aware of them before applying. The most significant are the following:
- High interest rates: Though your actual costs depend on the lender and your credit score, personal loans typically have higher maximum interest rates than business loans.
- Low principal balances: Personal loans usually don’t let you borrow as much as business loans. If you need more than $100,000, a personal loan probably won’t be sufficient.
- Short repayment terms: You usually have less time to pay back personal loans than business loans. They typically don’t last longer than seven years. That can indirectly cause you to have higher monthly payments.
Ultimately, business loans and personal loans both have their place. You should probably go with a business loan if you have a company that needs financing and can qualify since they usually have more favorable terms.
However, if your business doesn’t have the necessary credit, time in business, or annual revenues for a business loan, a personal loan is a viable substitute.
And of course, if you’re looking to finance something that isn’t business-related, like medical bills, debt consolidation, or home improvements, you won’t be able to use a business loan.
FAQs
Which Loan Is Best for Business?
Business loans are typically better for business than personal loans. They generally have higher principal balances, longer repayment terms, and lower interest rates. They can also help you build business credit.
However, business and personal loans can both be viable financing solutions for your company. In practice, the best loan for your business depends on what you can qualify for and your unique needs.
While business loans often have better terms, they can be harder to get than personal loans, especially for new businesses that haven’t had time to develop sufficient credit or revenues. In such cases, personal loans might be all that’s available.
Can Personal Loans Be Used for a Business?
Yes, you can often use personal loans for business purposes. Personal loans are among the most flexible form of financing. However, there are exceptions, and you should always confirm that your lender has no restrictions before applying.
If a lender does say that you can’t use your personal loan for business purposes, don’t try to get around the rules. Using the money for prohibited expenses could cause the lender to demand that you pay back your principal and interest ahead of schedule.
If you take out a personal loan for business, it’s a good idea to direct the funds to a bank account that’s separate from your personal funds. Otherwise, it can muddy the waters when you need to figure out your allowable tax deduction for any interest paid.
Is a Business Loan Better Than a Personal Loan?
A business loan isn’t inherently better than a personal loan. They’re both viable sources of financing. The superior loan option depends on your needs and the account terms you can qualify for with your personal and business credit scores.
That said, business loans are generally better for financing your business needs. They typically have higher loan amounts, longer repayment terms, and lower interest rates.
However, personal loans are much easier to qualify for than business loans. If you don’t have an extensive business credit history, a personal loan may be better for your company.
In addition, you generally can’t use business loans to fund personal expenses. As a result, you’ll need to use a personal loan if you want to make improvements to your house, pay for medical bills, or consolidate your personal credit card debt.
