Hiring staff, buying equipment and facilities, ramping up marketing... Whatever it takes to grow a business requires funding. One type of funding is borrowing.
Borrowing from yourself assumes your business is doing well, and you have taken distributions to have the personal resources available. Third-party borrowing could be from a bank or other financial institution, an equipment supplier or vendor looking to increase their sales.
Which type of borrowing makes the most sense for you? It depends on your situation.
Reasons That Favor Borrowing From Yourself
1. Time crunch. A third-party lender will have a structured process: an application, submission of a business plan and financial information, internal review and approval, etc. This could all take up to a month.
If you borrow from yourself, it might take a day. If speed is an issue, borrowing from yourself is usually quicker.
2. Loan terms. A bank will have a suite of standard “loan packages,” which include terms such as loan length, collateral requirements, and principal and interest payment provisions.
While banks can be somewhat flexible, they have their base products. If you borrow from yourself, you can set the terms and change them if necessary.
3. Interest rate. Banks and other lenders are in business to make money. Interest rates are made with profit margins in mind, as well as a risk factor to hedge that you might not pay back the loan on time.
When borrowing from yourself, you can set a low rate as long as it complies with IRS regulations. The IRS regulations are at section 7520 for Applicable Federal Rates and section 7872 for Treatment of Loans with Below Market Interest Rates.
4. Loan capacity. If you already have loans, a new loan might exceed the bank’s debt service coverage ratio metric. (The ratio metric is a measure of the amount of cash flow available to pay debt obligations.)
If this is the case, a new bank loan might not be available for you.
Reasons That Favor Borrowing From a Third Party
1. Amount of funding needed. If the project, equipment or staff hire cost more than you can fully provide up front, then you may need funding help.
While you might be able to take a slower approach and self-fund over time, it might be important to make the investment soon to take advantage of a market opportunity.
2. Creating banking relationships and establishing your credit worthiness. Corporate treasurers often quip that the best time to borrow is when you do not need the money. At these times, you may be able to negotiate favorable terms.
Borrowing when you least need can help establish a relationship with the bank, which may come in handy when you really need them. Also, paying back the loan on time can help establish a good credit score and D&B rating. Further, having achieved bank borrowing may demonstrate to other potential funders that you have successfully passed the bank’s due diligence process.
3. Length of loan. Say you want to borrow and spend the money today to generate cash to repay the loan in a few months. In this type of temporary loan, a bank line of credit might be appropriate.
If the payoff period is longer or if there will be other cash needs, then a term loan might be appropriate as the borrowing level is more permanent. Remember, the interest expense is tax deductible.
Read more articles on financing.
The information contained in this article is for generalized informational and educational purposes only and is not designed to substitute for, or replace, a professional opinion about any particular business or situation or judgment about the risks or appropriateness of any financial or business strategy or approach for any specific business or situation. THIS ARTICLE IS NOT A SUBSTITUTE FOR PROFESSIONAL ADVICE. The views and opinions expressed in authored articles on OPEN Forum represent the opinion of their author and do not necessarily represent the views, opinions and/or judgments of American Express Company or any of its affiliates, subsidiaries or divisions (including, without limitation, American Express OPEN). American Express makes no representation as to, and is not responsible for, the accuracy, timeliness, completeness or reliability of any opinion, advice or statement made in this article.