Debt isn't bad for new businesses, but too many entrepreneurs use it wrong.
Debt can be used as an effective tool to start a business and create a company. However, debt can also become a trap that puts you at risk for bankruptcy and a failed business.
As a new entrepreneur, you may not yet realize how to manage debt correctly. If you can avoid these five common debt traps that I’ve seen among many new entrepreneurs — and even I — have come close to falling into, you may be able to use debt to finance your business and keep your head above water…
1. Credit card rewards
It may seem like a great idea to get credit cards that offer rewards and points for using credit, but they can become a trap if you don’t pay off your credit card balance each month. A new entrepreneur may want to carry their debt forward while they wait for revenue to pour in that can then be used to pay it off.
In the meantime, they will get rewards that they can use to buy equipment or office supplies that would help the business. While it’s a nice idea in theory, the reality is that you need to spend thousands of dollars before the points or rewards really get you anything worthwhile. Meanwhile, you’ve racked up considerable debt that you can only make the minimum payment on, creating more financial pressure and putting you into a debt trap that is difficult to escape.
2. New car
I am guilty of this debt trap. As a young entrepreneur, I did quite well in my regular job so I decided to treat myself to a new luxury car. However, once I wanted to transition to the life of an entrepreneur and build a business, the new car loan payment each month became a huge burden.
I struggled to make the payment without my regular salary. It turned out that I had to sell it in order to keep my startup going. Instead, I opted for a used car that was more practical and less luxurious. In the scheme of things, the desire for a new car faded when I had to choose between it and the opportunity to become a successful entrepreneur.
3. 401(k) raid
Many advice articles on funding a startup now list borrowing from your 401(k) that you may have had from your previous jobs. While the loans come with low-interest rates and are tax-exempt, the problem is that you are borrowing from yourself and putting a huge dent in your future retirement fund.
You are missing out on the growth potential that the money would have made if you left it in your account because you want to fund your business now. Look for other funding options before you break into your own bank account and compromise the financial security you need for retirement.
While first impressions are everything, especially in business, it doesn’t mean you need to spend what you have on a designer wardrobe. Many young entrepreneurs like to dress the part in expensive suits, but that money could be used to fund the practical things you need while you ramp up your business.
In reality, think about people like Steve Jobs and his black turtlenecks and Mark Zuckerberg’s flip flops. It’s not the clothes that make the entrepreneur; it’s the ideas, drive, and determination that really impress.
5. Equity lines of credit
With home values returning, information about equity lines of credit has returned to tempt homeowners. A way to tap into home values and take that equity out to fund whatever they desire, this may at first seem like an ideal way to finance your startup. But these equity lines become dangerous and lead to many losing their homes when values plummet.
The interest rates are low and the payouts are often big so it becomes very attractive until you think about how you may repay the loans, which often require immediate monthly payments. When you don’t have a steady income, these payments can put significant pressure on you. There are better ways to fund your business than to risk your home, especially those of you that have a family that counts on the stability inherent in homeownership.
Before you consider these potential debt traps or you create debt through other sources, it’s a good idea to do your research and understand the risks involved in generating debt. Also, you can speak with a financial adviser who can help you create a budget.
Lastly, debt education classes are offered that provide more ways to become knowledgeable in debt management and asset management so you make smart choices if you opt to use debt to fund your startup. Of course, you can also choose to enjoy a debt-free lifestyle and still start a successful business.