Is a dad loan better than a bad loan?

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Dear Business Banter,

My dad said he would lend me $50,000 to start my business. I would repay him in three years at 2 percent interest. He is retired and money is tight, so this is very generous of him. My credit is decent, but I don’t think I could get a better deal. Should I take his loan? – Amira

Dear Amira,

On the surface, borrowing your father’s money makes perfect sense. An interest rate that low is hard to beat, after all.

To repay it in the agreed-upon time frame, the total interest would be $1,578—an almost negligible sum for such a large loan. However, the installment payments would be about $2,150, which is substantial for a business that, I presume, has no revenue yet. You’d have to be sure that you can consistently afford that monthly outlay, as well as cover your venture’s operating expenses and your own income.

So how does your dad’s loan compare to a business loan you would get from a private financier? Let’s find out.

Have a business question for Erica? Drop her a line at the Ask Bankrate Experts page.

SBA loans

The Small Business Administration (SBA) partners with lenders to provide loans to qualifying small businesses. Their most common SBA-guaranteed loan is the SBA 7(a), and it currently has APRs between 6 percent and 8 percent APR. A $50,000 loan at 7 percent APR with the same three-year term would have payments of $1,544, and the total interest would be $5,579.

If your credit is very good, you may be able to get a better deal directly from a conventional bank, online lender or credit union. Currently, these business loans start at around 6 percent. A 3-year loan at that rate would have a monthly payment of $1,522, and the total interest would be about $4,760.

Clearly, accepting your dad’s source of capital instead of a financial institution’s would save you a lot of money. However, that’s only looking at the situation from the financial angle. There are other important factors to consider:

  • The well-being of a loved one. You do not want to put your father in any kind of financial bind (should he end up needing that money) if you can’t follow through with the payments. Because he appears to be on a budget, you would have to be absolutely certain that he can afford to live without the cash and that you will repay the debt.
  • Business credit history creation. By just using your father’s funds, you won’t be creating a positive credit history. As a small business owner, you will want to have as much attractive data being reported about your loans and credit card activity as possible, so you can borrow from a financial institution with preferable terms in the future.
  • Lender relationship. When you work with a bank or credit union, you form a valuable connection with that lender. Even if you’re still in the process of building high credit scores, your on-time payment pattern and eventual debt repayment with that financial institution will set the stage for additional credit products.
  • Rewards and perks. You don’t mention having a business credit card, but having one is essential. You will need to keep all of your spending separate from your personal life, and most of these cards are equipped with benefits. They often include a generous rewards program where you earn points, miles or cash each time you make an eligible purchase. Many offer 0 percent APR for a year or longer, as well as large sign-up bonuses and embedded perks, like travel discounts and expense tracking features.

Other options

Because a loan from your father has significant downsides, and you would forfeit the benefits associated with other products, I suggest taking a more creative and diversified approach.

For example, here’s an alternative plan to borrow the $50,000:

  • Apply for a great business credit card. There are plenty from which to choose. As an example, the Ink Business Cash Credit Card from Chase offers 0 percent for 12 months, and a $750 cash credit for spending $7,500 on purchases in the first three months of opening the account. Charge $15,000, then repay the balance in fixed $1,250 increments. You’ll be debt-free within the year, so no interest would be added, and you’d score that sign-up bonus. Review all of your options and select the account that best matches your credit rating and needs.
  • Take out a low-rate small business loan and extend the term. If you borrow $15,000 at 6 percent APR and repay it over five years, the monthly payment would be $290, and the total interest would be $2,400.
  • Accept the remaining sum from your dad. As long as you feel totally comfortable borrowing your father’s money, and it won’t impact his lifestyle at all, accept a greatly reduced loan amount of $20,000. Payable over three years, the payments would be $572 and cost $623 in interest.

A plan like this would not just place far less of a burden on your father, but you’d gain all the benefits associated with credit cards and loans.

But would it be feasible or cost you more? Let’s look at the numbers.

Fine print

In the first year, your payments would be $1,250 (to the credit card) + $290 (for the loan) + $572 (to your dad) = $2,082. After a year has passed and the credit card debt is deleted, your combined payment drops to $830.

The interest you would pay is $2,400 (to the loan) + 623 (to your dad) = $3,023. But wait, subtract $750 for the bonus you earned with the credit card! That brings the total financing fees to $2,273.

Yes, this exceeds the amount you would pay for just your dad’s loan by about $700, but you can send the portion you no longer have to pay the credit card to your father or the lender. This way, you would pay those obligations off faster, thus reducing the overall interest costs.

Also, by using the credit card after the introductory period ends for your operation costs and keeping the debt to zero, you’ll rack up rewards that translate into profits!

Although it may be easier to just accept your dad’s offer, a more nuanced approach to financing your start-up has far greater—and longer-lasting—advantages.