Small Business

Don’t Fund Your Small Business Dreams With Credit Cards

Small businesses face staggering odds. About a third go under in the first two years, while half fail after five. To avoid this fate, many owners will tap the credit cards in their wallets to weather volatile times, a strategy that can have lasting consequences.

A third of small business owners reported using credit cards in the past 12 months to meet capital needs, according to a survey last year from the National Small Business Association. Without the funding, owners might have been forced to lay off employees, abandon expansion plans or reduce employee benefits. There are other alluring pluses, too. Financing your business on your existing credit cards allows you to bypass the application process and waiting period required for other financing options, such as business loans. The additional spending can earn you a bigger rebate on your cashback card or more miles on your airline card. If your personal cards are maxed out, you can easily get a small business card that’s based on your credit history rather than the track record of the business.

Why It’s A Bad Idea

But there are downsides to a card-financed enterprise. The first is that it mingles your personal finances and those of your business in a way that can be treacherous, says Bruce McClary, spokesman for the National Foundation for Credit Counseling. “[People] are lured by the hope that they will be able to achieve financial stability with the extra cash flow,” he says. But if they don’t separate their personal credit from their business, they “can find themselves in a financial mess if their business is not successful,” he says.

Credit card debt is also expensive, with interest rates averaging about 12.5% this year, according to ValuePenguin’s analysis. But that rate can skyrocket to a penalty rate of 29.99%—the maximum allowable rate on a credit card—if you miss one payment or max out your credit line, real possibilities if you and your business are struggling financially.

Racking up debt on your credit cards hurts your credit score, too—which is true even with small-business cards if they’re based on your personal credit score Using too much of your available credit (called your utilization rate) lowers your score. And if you’re late on a payment, that again dings your score. This can hurt you down the road. Your creditworthiness is key to qualifying for many small business loans and it’s also important to your personal finances. A poor score can make it harder for you to get a mortgage, auto loan or even more credit cards.

What happens when your business doesn’t pull out of its swoon, but you continue to finance it anyway? If you can’t pay back the credit card debt you piled on, you may have to shutter your company. Even worse, you may be forced to file for a personal bankruptcy—rather than a business one—since the debt is tied to you personally. This will haunt you for 10 years on your credit report, making it almost impossible to get any credit.

What are the alternatives?

So if credit cards shouldn’t be your first go-to for you small business, what should? Personal savings is by far the biggest source of startup and expansion capital, according to the SBA. But if you need to borrow funding, there are less expensive options than credit cards.

Loans: The Small Business Administration guarantees loans with rates between 6.5% and 8%, while online lenders offer faster loans with rates as low as 7%. Depending on the loan, you will need good business plan, strong credit and collateral. You may also be required to personally guarantee a portion of the loan, but terms can be negotiated.

Equity: Small business owners can also to sell an equity stake to a close relative, like parents or grandparents, to get cash, says David Haas, owner of Cereus Financial Advisors in New Jersey. There are also crowd-funding portals like NextSeed, SeedInvest, and Wefunder, where small businesses can raise up to $1 million from investors.

Other: Haas also suggests factoring, where you sell your accounts receivables to a third-party company at a discount in exchange for an upfront, lump-sum payment that you can use for working capital. This option is typically costlier than traditional bank loans, but is available to struggling businesses or owners with blemished credit.

How to Avoid Trouble

“When small business owners come in for help, they are in one of two phases,” says Kim Cole, the community engagement director for Navicore Solutions, a non-profit credit counseling firm. “They are either trying to start up a business or save a failing one.”

Often, their credit has been tarnished so much they can’t get a small business loan. They are typically sole proprietorships who have stopped taking paychecks to prop up a floundering business and are unable to keep up with bills at their business and home. “They are often seeking money,” when they come in, Cole says, and “not advice.” Don’t make that mistake.

When your business hits a wall—either during startup or after years in operation—get help from groups like C12, SCORE and the Small Business Administration (SBA), which can review and tweak your business plan and operations to help it survive. Find attorneys and financial advisors that specialize in small businesses and have your best interests in mind, says Mark Kemp, a certified financial planner in Pennsylvania.

If your business can’t be saved, find another job, focus on regaining financial security and let go of your former business. “There’s a difference between a great idea and a great business plan,” says Kemp. “And a great idea can easily become a financial disaster.”

Janna Herron

Janna is a Senior Writer at ValuePenguin covering banking, credit cards and credit scores. She has spent more than a decade writing and reporting on personal finance, real estate and business, and has received three journalism awards for her work.