When entrepreneurs start a business, in many instances, they don’t have capital, and the business hasn’t been around long enough or generated enough income to be risk-worthy for a loan.
When you want to start a business and don’t have enough savings needed for the costs to get a business running, you might be tempted to take a personal loan. This is a common practice. However, there are ways to go about it.
In this article, we’ll discuss whether taking a personal loan is the best approach to starting a business, and how to approach it in the best way.
Know the Difference Between a Business Loan and a Personal Loan
When you’re just starting, it’s easy to blur the line between business and personal finances. It’s crucial to clearly understand the difference between a business loan and a personal loan. 99% of businesses in South Africa are bootstrapped, indicating that few receive business loans, at least in the early stages of their businesses.
Business Loan vs Personal Loan
Business loans are loans directed at the needs of a business. Business loans offer larger amounts and longer repayment terms.
In some instances, there are lower interest rates when a business is able to display strong credit and financial behaviour. Lenders for business loans check cash flow, revenue, and collateral belonging to the business.
Personal loans are tied to the individual’s income, credit score, credit behaviour, and ability to repay the loan. Unlike a business loan, personal loans do not look at company earnings.
Can You Take a Personal Loan for Your Business?
Yes, you can definitely take a personal loan for your business. But, since personal loans don’t have the same benefits as a business loan, you must be careful in your approach.
Lend Your Own Money to the Business as an Owner Loan
If you decide to use a personal loan to fund your business, you can structure it by lending that money to your company as an owner loan, also known as a shareholder loan. This approach helps keep your personal and business finances separate.
By using a personal loan in the business as an owner loan, you create a clear paper trail that shows the money entered the business formally. A clear paper trail is essential, as opposed to funds being mixed with operational income.
How does this work?
- The business records the loan as a loan payable.
- You, as the owner, record it as a loan receivable in your records.
- You can charge a market-related interest rate, which allows the business to claim the interest as an expense.
- The interest can be added to the loan balance.
This approach provides transparency, strengthens your business records, and can make it easier to qualify for formal business funding later.
Tax Considerations in South Africa
When lending to your business as an owner or shareholder, you must ensure you consider the tax and legal aspects of a shareholder loan:
Charge a Market-Related Interest Rate: The interest rate must reflect a realistic, market-related rate. If you charge a low interest or a very low rate, it triggers section 7C of the Income Tax Act, which treats the difference as a donation subject to donations tax at 20%.
Annual Interest Exemption: Individuals can benefit from the annual interest exemption currently R23 800) for interest income, which can reduce personal tax liability.
Company Deduction: The company can deduct the interest paid to you as an expense, reducing taxable profits.
Documentation: Always have a formal loan agreement, repayment schedule, and proper bookkeeping entries.
Benefits of Using an Owner Loan Structure
Keeps finances separate: Personal and business funds should not be mixed in order to maintain financial compliance.
Maintains transparency: Clear records are essential for future audits. Additionally, it makes it easier when your business applies for funding.
Builds business credit: Shows lenders that the company is responsibly managed.
Flexibility: The interest owed is added to the loan balance instead of having to pay it now. This saves your business cash during its growth phase.
Risks of Using an Owner Loan Structure
While an owner loan structure can be beneficial for your business, there are risks. Even with an owner loan, there are risks:
- If the business fails to make money, you may lose the money you invested.
- Incorrect interest rates can trigger donations tax.
- Poor documentation can lead to accounting and legal complications.
Before rushing to take a personal loan, make sure you have explored the reasons why you’re not getting a business loan. Apart from not being lender-ready, other reasons include that your business finances are all over the place, you’re asking for the wrong type of loan, your credit record is a mess, and a range of other reasons.
