Personal
Financing
"Save a little money each month and at the end of the
year you'll be surprised at how little you have." —
Ernest Haskins
Most small startup business are initially funded by the
personal assets of the entrepreneur. Some funding for your small
business is likely to come from your direct contributions of
personal savings or assets to the business (e.g., an early
retirement incentive payout). Additional personal funds are
often contributed after the entrepreneur borrows money through a
personal (consumer) loan and then contributes that money as an
equity investment into the business.
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The majority of consumer loans will require
that you secure the loan with an equity
(ownership interest) in an asset that exceeds
the amount of the loan. Unless you have an
extremely solid personal credit history with a
commercial lender, the institution is unlikely
to grant an unsecured loan to a startup
business.
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There is a great variety of personal assets that you can use
as collateral
to obtain cash from a lender, but perhaps the most common source
is a residence. You can use this asset to: obtain a first or
second mortgage,
to refinance
an existing mortgage, or to secure a home
equity loan or line of credit. The major disadvantage to
using your house as collateral is that default on the loan can
mean forfeiture of your home.
Nearly all commercial banks and residential lending
institutions will have options available for home-backed
financing. The period and computation of the rate of interest,
upfront points, closing costs, administrative costs and burdens,
the length of loan, loan conditions, and default terms all
affect the real
cost of a loan. Whether or not the local lender will sell
your mortgage to another creditor may also be a consideration
for you.
For second mortgages or lines of credit, you should
anticipate that lenders will allow a maximum total mortgage
debt, including preexisting mortgages, of approximately 70
percent to 85 percent of the current market value of your
residence. Recently, some lenders have begun offering financing
up to 100% of your home's current market value, but interest
rates are steep, and the risk of losing your home if your
business fails make these loans a last-ditch choice for most
budding entrepreneurs.
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If your property is currently valued at
$180,000 and you have an existing mortgage of
$80,000, your equity value in the house is
$100,000. If the lender's maximum loan-to-value
percentage is 80 percent, your maximum second
mortgage would be for $64,000. The reason for
this is that you must continue to maintain at
least 20 percent equity in the home ($36,000),
leaving $144,000 available to be financed.
$144,000 - $80,000 (your existing mortgage) =
$64,000.
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Also, be aware that second, or even third, mortgages will
typically have higher interest rates than first mortgages
because the lender is subordinate to a prior mortgagor. (In
other words, if you default on the loans, the first-mortgage
lender will be paid off first, and the second-mortgage lender
may not be paid at all.) In instances where your interest costs
would not be significantly increased, you may be better off
refinancing the existing mortgage for an increased loan amount
rather than taking a second or third mortgage.
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In the event real estate is to be used as
collateral, borrowers should be aware that banks
and other regulated lenders are now required by
law to obtain third-party appraisals on real
estate-related transactions of $50,000 or more.
Certified appraisals are required for loans of
$250,000 or more. When commercial real estate
represents the major piece of collateral for an
loan, the SBA will also require a third-party
appraisal.
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Other than your residence, other commonly used collateral for
secured consumer loans include other real estate, life
insurance policies , any existing machinery or other
business equipment, stock, and pension plans.
For instance, you can usually borrow the cash surrender value
of an ordinary life insurance policy. You are not obligated to
repay the loan principal, only to pay interest on the loan. The
rate of interest charged depends upon when the policy was
purchased; rates on older policies might be very favorable. Of
course, borrowing against your own policy means the eventual
death benefit of the policy will be diminished by the amount of
the loan, plus the loss of interest.
You may also have other assets in your personal portfolio
that permit you to borrow from them or that can be used as
collateral in a conventional loan. For example, if you have an
employee retirement plan, you may be able to borrow against
those savings up to a certain percentage of your total plan
value. Marketable securities can also be pledged to a bank as
collateral for a loan.
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Work Smart
If you can qualify for a consumer or home
equity loan, you might be better off not
disclosing that the purpose for your loan will
be a new small business. Conservative lenders
may be more skeptical of making a consumer loan
if they know that the money will be invested
into a startup business.
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