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Self-Financing Your Startup: Understanding the Credit Risks

Self-Financing Your Startup: Understanding the Credit Risks

Most entrepreneurs get their enterprises off the ground by financing them with personal funds. Although this is a tried-and-true method, what’s not quite as widely known is how it might impact your credit rating.

Starting a new business is exciting but also intimidating, especially when it comes to finances. Finding the right mix of capital requires educating yourself on the available options. This is followed by evaluating risks and opportunities of each method, for your individual situation. There is no one-size fits all. Investors will ask you to be the first one that believes in your dream and backs it with at least a part of the necessary amount.

The key is to think long-term and take into consideration the impact of your decisions on your FICO credit score. Borrowing lowers it and missing payments can destabilize it completely. A small FICO can lead to higher interest rates and more money owned, triggering a downward spiral.

Unfortunately, the most common ways to get the money for a start-up, especially a small one under 5 employees, remain credit cards and borrowing from relatives. Yet, there are numerous other ways to get lucrative capital that are less expensive than a credit card and put less social pressure on the entrepreneur. A wise start-up founder could leverage the equity of their home, life insurance, or savings accounts as well as other assets. We shall discuss each of them, arranged according to the risk they carry.

Credit Cards

Most start-ups are born from credit card money, but this is usually a costly decision. The average APR is within the 12-20% range, and starting a business can push your debt to the credit card limit. Thus, it follows that you will get a higher debt burden, which makes up 30% of your FICO score. Therefore, even if you pay on time, you will still have a lower rating, which translates to a higher interest for any subsequent loan or new credit card you want to get.

Also, if you have a slower time in business, you risk accumulating high-interest debt and missing payment deadlines. This can affect the most important FICO indicator, the payment history, thus lowering your score even further. Such choices also create the inability to get loans at a better rate later.

Home Equity

One of the lowest rates you can get on a loan is by using your home equity and getting a second mortgage on the share you have already paid for your home. You can expect an APR around 5%, which is less than half or even a quarter, compared to credit cards. Also, the interest paid on home loans may be tax deductible, so you get some free money, which is another plus compared to credit cards.

The downside of this approach is that missing a few payments could result in losing your house, which is a high risk to consider, especially if you have no prior experience in managing a business.

Retirement Accounts

Employees keeping their full-time job who have a 401(k) can borrow up to half of their vested account balance (up to $50,000) and repay it at a low-interest rate to self-finance. The only danger is that in case you are fired, you need to replace funds in 60 days. A similar situation occurs if you own an IRA and decide to borrow money from it. You are only allowed to withdraw cash and use them for 60 days, after which you become taxable and pay a late fee. Juggling with multiple IRAs can keep this cycle going for longer, but it is risky.

Securities

Having some investments gives you leverage and the opportunity to use them to get a personal loan at a very competitive rate. This prevents risking your home, as previously described. The only trouble with this approach is that you can be asked to come with additional collateral. However, this only happens if the markets fall so much that the initial value of the collateral doesn’t cover the loan and interest anymore.

Savings Accounts, Collections, and Other Assets

Looking around you can be eye-opening, and you can uncover items of value that can be converted to money and used to start your entrepreneurial journey. Maybe you have a valuable antique or a collection of old stamps that no longer appeal to you and you want to use them to fuel your dream. Savings accounts are also an option, which carries no interest or risk.

When choosing your funding source, make a comparison table between alternatives, looking at both monthly spending and total costs. Don’t forget to assess each item for relevance and necessity, don’t spend money on what you don’t need, and always estimate the time it takes to get a return on your capital.


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by Lottie Pritchard // Lottie Pritchard is a contributor to Businessing Magazine.

Opinions expressed by contributors are their own.