Many people have the urge to pursue their dreams and open their own business. They have spent their lives working for a company, slowly but surely building their 401K, but it is time for them to branch out and try their own luck. These entrepreneurs often find themselves faced with some difficult questions; many of those questions regard money and the right way to get business funding.
The entrepreneur may have two common ideas in mind: either take money out of his or her 401K, or take out a business loan. Both options have their advantages and disadvantages. Small business capital funding can shape the way your company will operate, so let’s examine these two options to help determine which is right for you.
Pros of Drawing From Your 401K
Initially, drawing from your 401k might seem like the smart choice. For starters, this is your money, and you have an exact amount that you know you are eligible for: it already exists in your account. Additionally, this money will not have an interest rate associated with it. Once you take the money out, there is no chance of owing interest on it (though you might have to pay a penalty, which will be addressed later). Also, there is no wait-and-see for approval. This money is yours, and there is no chance you can be denied access to it.
Cons of Drawing From Your 401K
However, there are some downsides. First, early withdrawals from your 401K usually come with a fee or penalty. No, it is not interest, but it is your money being spent on something that does not help your business. Furthermore, your 401K needs money actually in it in order for it to compound: that’s the interest you should be most concerned with. Your years of hard work start to pay off the most at the end of their life, because that is when the most money is gaining interest. Finally, come tax season you will have to allocate some of the money to pay the taxes on what you withdrew, depending on your age. This is yet more of your hard-earned money that is not compounding interest or being used towards your business endeavor.
Pros of Obtaining a Business Loan
One of the biggest upsides to obtaining a loan versus borrowing against your 401K is the options available to you. The duration of your loan, the amount, and the interest rates are variables that can often be negotiated. With options, you have control over the timeframe to repay the loan and how much interest it will accrue during its lifetime. A business loan also has the potential to be larger than your 401k, which will help your company grow faster from the outset.
Cons of Obtaining a Business Loan
Many people might be turned off at the idea of taking out a business loan. The idea of starting your company in the red is not appealing, and the idea of waiting several weeks to hear back if your application was accepted is even less palatable. There is always the possibility of being denied a loan as well. What you would do well to remember is that there are numerous lenders out there. If you need a business loan fast, there are some lenders that offer same-day small business loans.
A small business loan also gives you another entity with a vested interest in your company. As your company succeeds, they will feel confident and secure that they invested their money with you. Also, if the need arises, you can go back to your lender for another loan in the future if necessary. With a 401K, there is a finite amount of money you have access to. Building relationships with your lender can also give you a better understanding of how to develop other relationships crucial to your company’s success.
Though both avenues can be successful ways to fund your business, taking out a business loan more often than not is the better option in the long-term. Most bankers would agree that allowing your 401K to mature and continue to compound interest would be the best place for that money. A small business loan can create opportunities for you overburdening you with debt. Since you have been savvy enough to save into your 401K, navigating a small business loan will not be a problem.