Can You Use a Business Loan to Pay Off Personal Debt? 5 Problems It Creates

The short answer is no. It can be tempting to use a business loan to pay off credit card debt or other obligations you have. But it can create a series of negative consequences and even put your business at risk. Taking out a business loan for personal expenses violates your loan agreement with your lender and puts you in a tricky legal position. Here are five good reasons why you shouldn’t use a business loan to pay off personal debt.

Serious Consequences

Using a business loan to pay off personal debt breaks your loan agreement. Business loans are for business use only. Using the money for personal reasons could prompt your lender to call your loan, a term for when the lender demands immediate repayment of the entire balance. On top of that, the Small Business Administration bars entrepreneurs from using business loans from the agency to make distributions to owners, except for reasonable compensation for work.

SBA loans generally require a personal guarantee from any owners with a 20% or greater stake in the business. If you personally guarantee a business loan, the lender could come after your personal finances if your business can’t make payments on the debt. Business loans also generally lack federal consumer-credit protections, unlike consumer loans, which are covered by Regulation Z.

As long as funds from your business loan are used for legitimate business expenses, the interest you pay on your business loan may be deductible from your business income. Your business loan interest may become non-deductible if the money is used for personal expenses. Using a business loan or business credit line for personal expenses could trigger the IRS to consider the debt to be for personal, not business purposes. If you claim the deduction anyway, the IRS could see taking a loan for personal use as a distribution of funds or compensation, which may be taxable income on your personal tax return. You could risk an audit or other issues with the Internal Revenue Service. In general, it’s a good practice to keep your business and personal finances separate.

Corporations and LLCs offer their owners limited liability protection against the actions of the business, but that liability protection can be put in jeopardy if you mix personal and business finances. When you mix business and personal finances, you open yourself up to creditors or others who seek to sue your business. A judge could decide to disregard your business entity - a process called piercing the corporate veil - to gain access to your personal assets.

Using a business loan for personal reasons can cause legal issues. Taking out a business loan based on fraudulent information can expose you to civil lawsuits and even criminal penalties. Knowingly lying to obtain a loan from a federally insured financial institution is punishable by a fine of up to $1 million and up to 30 years in prison. While you may not be outright lying when taking out a business loan to cover personal expenses, misusing loan funds is a violation of your lender agreement that can lead to serious consequences.

Finally, using a business loan for personal expenses could make it harder to obtain credit in the future. Your lender might see you as untrustworthy if you misuse your loan funds. If you default on a business loan, it could hurt your credit score and prevent you from being able to access other financing in the future. If you’re applying for a business loan, personal transactions or unexplained withdrawals on your business bank statements could lower your approval odds. Lenders may review these statements as part of the application process.

The Recommended Way to Access Your Earnings

Paying yourself a salary from your business, or a draw from the earnings, is the recommended way to access your earnings from the business. Writing a salary check to yourself is just like paying any other employee. It needs to be reasonable - comparable to what others in your industry earn. And you must withhold taxes from your paycheck. When you draw from your profits, no federal withholdings are required. But you have to hold back enough to cover any taxes you owe. The amount of money available is limited by your equity in the business - money invested plus unspent profits. You can reduce the risk of mixing business and personal finances by recording every payment you make to yourself as you make it. Move the money from your business account to your personal account, then pay your expenses.

Use Personal Funds for Personal Expenses

A personal credit card works best for small costs that you’ll be able to pay off monthly. A personal loan is a better choice for larger expenses. Personal loans allow you to take out a lump sum of money that’s repaid with interest. Approval is based on your personal credit and finances.

The bottom line is that using a business loan for personal expenses violates your lender agreement, puts your business at risk and could lead to tax issues. Instead, use personal funds for personal expenses and leave business funds to grow and sustain your company.