In order to answer the question above, it is first important to understand what is meant by credit score. There are two types of credit scores that may be used in determining qualification for a small business loan,
The first type of credit that might be considered is Business Credit. Just like an individual has a business has a credit score. There are different scoring methods, reporting agencies, and scoring systems used.
Business Credit Score:
This is a numerical value given to describe the credit worthiness of any business. The score is determined greatly in part to the payment history of a business. Accounts used to determine the business credit score could be utilities, vendors, credit cards, loan history and any other debt that belongs to the business.
Consumer Credit Score:
This is a numerical value given to individual consumers based on their credit worthiness. Accounts examined generally are home loans, auto loans or leases, and consumer loans such as credit cards. Other items such as tax liens, judgement and collections are used in calculating the credit score. Scores range between 350 and 850. The stronger the payback history and length of accounts will help increase a consumer credit score.
What kind of credit is used for a small business loan?
When applying for a small business loan it is very likely that the lender will examine credit history of both the business and the business owners. Although the space concerned is business lending, there are different analytics used for small business than there is for larger businesses. It is true that there is a legal and identifiable difference between a business and its owner or owners. But it is important to keep in mind that there is a difference between a smaller company (under $25 million in annual revenue) and a larger company ($250 million plus in annual revenue). As a company gets larger, the structure of the company becomes more complex. It is likely that a company will more than $250 million in annual revenue will have dozens or even thousands of shareholders (owners). With a small company, it is more likely that there is a smaller ownership structure that is less easily distinct from the business per se.
Is Business Credit important in obtaining a small business loan?
Business credit is the most important factor in obtaining a small business loan. Every loan program that offers credit to businesses will look at the credit score of the business. Many programs have their own scoring models. What is most important is having a good history of payments no matter what model is used to score the business credit.
The best thing a business can do is pay the bills. I know this sounds obvious and it is obvious, However, most small business owners do not realize that past dues and unpaid bills are tracked similar to overdue bills are used to calculate consumer credit score. It is common to think of credit as mortgages, car loans, student loans and credit cards. Consumers do not receive history for payment history with the gardener or utility companies. However, businesses do have their history tracked in these areas.
Just like with consumer debt, when a business is trending downward, where there are increasingly long past due periods on an expanding number of accounts, a business is scored lower. Many small business loan programs will not approve an otherwise strong business, if there is a pay history on business accounts trending in the wrong direction. If a business is over 90 days late to a vendor, they decrease their chance of being approved for a small business loan or will be subjected to terms reflecting a riskier loan. In other words, it might cost more if the business owner is able to get approved.
Is consumer credit important in obtaining a small business loan?
The answer is probably but not necessarily. Consumer credit can be used to determine the credit worthiness of a business owner who is looking to obtain a small business loan. The industry trend is that better products and terms will be offered to those who have a strong individual credit history as well as good business credit. Still there are programs that do not look at consumer credit scores from any consumer credit bureau. These bureaus generally include Equifax, Experian and Transunion. Even though a program doesn’t look at credit score, the underwriter is likely to consider items such as mortgage and auto payment history, as well as availability of revolving (credit card) credit.
When it comes to offering credit with a small business loan, many different items are used by a lender to calculate risk. IT would be naive to think that a lender, even on programs that do not require a personal guarantee or collateral, will not use every tool at their disposal to predict the risk of lending to a business. These tools included both business credit scores and personal credit scores. The history of the business owner, as well as the history of the business, fairly or not, will be used to in the underwriting determination. The better job a small business owner does in maintaining positive business and personal credit, the more opportunities the business owner keeps open in terms of small business loans. A strong pay history will make a creditor feel much more at ease when offering credit, especially unsecured credit.
How are business credit and consumer credit used in approving a small business loan?
As we know see there are different types of credit, the role of each type of credit will be different in approving a small business loan. With business credit, the most recent trends as well as judgements, defaults and liens are likely to play a large role. In Contrast, the over all score of consumer credit is more likely to be used in approving a small business loan. Each can play an equal role. In other words, unlike any other type of funding or credit, small business loans consider both credit in defining risk. Each being a different indicator in the likelihood that funds will be repaid on a small business loan.
How is the role of consumer credit used for small business loans?
A small business loan, like any other type of credit, will examine the most similar credit first. For example, if a party is looking for a mortgage, the payment history of the party on the current mortgage is the largest factor. For equipment financing, a lender will look at larger, longer trade lines first. This is referred to as comparable credit. Auto loans and mortgage loans hold the highest significance. This will be followed by credit card debt. The reason for looking at auto loans first is that auto loans are paid back on a similar structure (roughly 5 years) with similar loan amounts to equipment. In terms of unsecured small business loans, credit cards and revolving debt are relevant because those are generally paid pack over a shorter time period and are not secured with assets.
Another area of interest is vulnerability to judgements or collections. If a business owner is in danger of being found at fault in a civil suit, it becomes increasing likely that the individual could file for bankruptcy. The same principal holds true for an individual with high levels of credit card debt. Once the individual becomes too overburdened with credit card debt, there becomes a growing likelihood that the individual will file for bankruptcy. A personal bankruptcy statistically has a negative impact on any business owned by that individual and increases the likelihood of a default. There also becomes an increased concern that the business owner lay use the small business loan to pay the personal debts, raising legal and affordability issues.
Consumer credit can be used in two primary ways when underwriting a small business loan request. It can be used to look at the behavior of the business owner. Does the business owner pay personal bills? Are there late payments or is the individual punctual? Consumer credit can also be used to tract current trends. Is the individual stretched for credit? Is the individual someone who uses credit as a responsible supplement to cash financing.
How is the role of business credit used for small business loans?
There are three primary areas to be examined in business credit. A small business loan underwrite will want to use business credit by examining the amount of debt serviced. A small business loan will also look at payment history and current trends in debt use and payments made on that respective debt. The goal in mind is to see if there are any red flags on the credit history of is the business credit history is a strong indicator of limited risk.
Many small businesses have debt that is not traditional to consumers. This will include items like equipment financing and other business loans or funding. The debt-to-income ratio, or the portion of revenue being used to pay creditors, becomes an important factor. An underwriter needs to be comfortable that a business can afford the payment and is not becoming over-leveraged. If a company has too much debt, affordability becomes a grave concern. At the same point, a business with a low debt-to-income ratio is a much less risky proposition for the lender of the small business loan.
Payment history is the most obvious factor. A company with a history of making payments on time is probable to make loan payments on time as well. This reduces the risk score of that business. In theory, even struggling to pay the electric bill is a strong indicator of financial stress. However, a business that pays its vendors and utilities on time, is probably managing its cashflow very wisely. Other areas such as defaults or successful pay backs are illustrated through the payment history.
Recent trends in business credit is vital for determining eligibility for small business loans. A company with recent past dues is likely struggling with cashflow. This does not preclude a business from obtaining funding but will raise red flags. A small business loan program is designed more for growth and less for taking on an already strained financial burden. We do not want to see one un-affordable debt being trade for an equally un-affordable debt. Many times, a small business is stressed for cash flow due to growth. In this case an underwriter may want to see Accounts Receivable reports and a Profit & Loss Statement in order to understand why the business is struggling to keep up with its obligations.
So, what is a good credit for a small business loan?
The answer is not as simple as stating a number…and that is a good thing! A program that will examine the entire picture is better than an automated program that uses a minimum cut-off in terms of credit score, either business or consumer. A small business loan program understands that there are complex decisions made daily when operating a business. Many times, these decisions are related to finance and credit.
Often a business owner will sacrifice their personal financial situation in order to keep funding their business. It is recognized that no person wants to be delinquent on their bills. The overall understanding of the consumer credit situation is what matters most. A small business loan is too important to be based on a solitary number.
A small business can become a victim of success. The faster a company grows, so does its bills. The first issue, on a micro level, is that growth will outpace speed at which receivables are being collected. The second issue, on a macro level, is that a growing economy will have a trickle-down effect on every level where terms were extended. If slow payment of financial obligations is a result of a growing business in a growing economy, there is much less concern for the risk of issuing a small business loan.
At the end of the day, when searching for a small business loan, it is most important to find a product for your company and situation. The stronger the creditworthiness of a business owner and the business, will result in more options and better terms. What is a good credit score for a small business loan? The best score generated by the best payment history, for both consumer and business credit, given all the circumstances surrounding the growth of the business, its industry and the general economy. The better someone is a paying their bills, the better results they will have in finding a small business loan.