Small business owners are optimistic. According to Dun & Bradstreet’s 2016 Economic Forecast, 81% of small businesses believe their businesses will perform better in 2016 than they did in 2015. This optimism exists despite the fact that small business owners’ believe that better access to capital would improve things even more. D&B’s 2014 Economic Forecast showed that 22% of small business owners said increased access to capital would help them expand. In the 2016 forecast, that percentage is now 26%. Getting a small business loan is usually a critical part of expanding. Unfortunately, bad credit often gets in the way of small business ready to grow.
Banks typically reject small business loan applications due to bad credit. And alternative lenders are here, ready to pick up the slack. Getting the right small business loan with an alternative lender not only provides needed capital – it can also help repair your business credit.
The Challenge of Bad Credit
When you or your business has bad credit, it makes everything more expensive. Ironic and cruel, right? Bad credit means higher insurance premiums, shorter accounts payable cycles that hamstring cash flow, and higher interest rates on credit lines or business loans.
It can even cause the loss of your business clients or vendors, and you’d never know. Unlike your personal credit report, your business credit reports aren’t confidential. Anyone can check them. Potential partners, vendors, and clients can check your business credit report to determine whether they want to do business with you. Since you don’t have the right to be notified when one of your business credit reports is requested, you may never know why you lost a bid; or even that a potential partnership opportunity existed.
Say a general contractor is taking on a project in a new area. He creates a short list of sub-contractors in that area to find some local partners. Your company made the short list. But the GC never got in touch after reviewing your business credit report.
So don’t just look at bad credit as an obstacle to overcome to access needed capital. Alternative lenders can get you over that obstacle. What you also want to think about is how to use the right business loan package to turn bad credit into good credit.
Understanding Personal versus Business Credit Scores
Understanding the distinctions between your personal and business credit scores is imperative. If you have a social security number, you have a personal credit score. The personal credit reporting agencies all use the standardized FICO system, which assigns credit scores on a scale of 300 to 850. Banks generally require a personal credit score of at least 680, while alternative lenders accept much lower scores.
To have a business credit score, you must first have a recognized, legal business entity. That means having an employer tax ID (EIN). Unlike your personal credit report, business credit reporting agencies don’t come find you. You have to register with them. Then, your creditors and vendors need to report your payment to them.
Another fun fact is that the business agencies don’t share a standardized scoring formula, like FICO. They each have their own proprietary calculations they use and gather information from different sources. The good news is that they consider many of the same factors (I’ll get to those below). But how they weigh each, or what else they consider, can differ. You should focus on the big three business credit agencies: Experian, Dun & Bradstreet, and Equifax. (You can check out a sample business credit report from Experian here.) While their credit score calculations differ, your small business will usually get a bottom line business credit score somewhere between 0 and 100. The lower the score, the worse your credit rating is.
At a high level, all the business credit agencies are looking to determine how likely it is that you’ll make future payments. They also want to assess the state of financial stress of your business. In other words, how at-risk is your business of closing? To do this, they may look at factors such as:
- years in business
- lines of credit/loans applied for in past near term (up to a year)
- number of lines opened or loans taken
- payment history: Do you tend to pay early, on time, or late?
- credit utilization: How extended are you? Are you carrying maximum balances on your credit lines?
- vendor payment terms: Do you have delinquent invoices? Or perhaps unusual payment terms that aren’t standard for your industry?
- company size
The extra challenge for sole proprietors is that vendors and lenders will still look at a combination of your personal and business credit scores when determining your credit-worthiness. In fact, if your business doesn’t have its own, separate legal existence (such as being incorporated as an LLC), your personal and business credit will always be mixed together. So a bad credit score in one area will negatively impact your other credit score.
So when deciding what kind of small business loan to take, and from whom, most small businesses need to consider the impact on both their credit scores. Here are four ways getting the right small business loan will help improve your bad credit rating.
- A Lender reports your loan and payments to all the right business credit reporting agencies.
As part of managing your credit scores, you should be monitoring what’s going into your report. You can report your own business loans and supplier contracts with the business agencies, but you want your payment history on that business loan reported as well. Payment history has to come from the lender or supplier.
During your due diligence investigation of your business loan options, find out exactly which business reporting agencies the lenders report to and what they report. Be aware that many merchant account loans aren’t considered business loans, so they don’t get reported to the business credit reporting agencies.
You also want to know how often your lender reports. It can take anywhere between 30 to 90 days for information reported to a business credit agency to actually show up on your report. The sooner your reported payments make it on to your report, the better for your credit score. Of course, it’s only better for you if you have a positive payment history.
Which gets us to tip #2:
- A chance to create a new payment history.
Every credit score relies heavily on how they quantify the risk that you won’t pay back, or pay on time, your loan. As long as you continue to have late payments or delinquent loans on your credit report, you and your business will have a bad credit score. If these are reasons why you currently have a bad credit score, getting a small business loan is an opportunity to start creating a new payment history.
With any active small business loans, it’s imperative that you make payments on time. Even better if you can make them early. Some business credit reporting agencies won’t give your business its top scores unless it sees you are making loan payments early. Although making them on time should be enough to get you into good score territory.
This is where short term business loans can be particularly helpful. Having a short term business loan means you can get a fully satisfied loan reported as quickly as possible. This may help you get your next business loan on better terms. It’s also why you don’t want to borrow more than you need, even if you qualify for more. If you take out too large a business loan, you increase your risk of having a missed or late payment. Some business loan terms let you connect your payment amount to revenue, which helps mitigate the chance that a cash flow pinch will result in a late payment.
Credit reports are all about your recent history. It’s not that a bankruptcy from a decade ago isn’t unimportant. But it’s less important than seeing a positive payment history over the past six to nine months, continuing forward.
When you have recent, paid-off short term loans, they crowd out the earlier, bad history. But be careful you don’t get the wrong things wiped off your credit report. You may lobby to get old, bad history removed. But there’s a myth that you should get past loans taken off your report as quickly as possible. Don’t do it.
The very fact that you had a small business loan that you paid off on time helps your credit score. You can’t show payment reliability without showing a payment history. Having a good payment history improves your credit score; having no payment history depresses it.
Needing to borrow money isn’t, on its own, evidence of financial stress. So don’t make the mistake of thinking that showing a need to borrow money reflects badly on your or your business. Borrowing money is a fact of life. The important question is how reliable are you in paying it back.
- Keep your credit utilization low.
A business loan isn’t business credit. Your business wants and needs both, but they’re different. Business credit is cash you have access to, via credit card or credit line, but don’t necessarily use. So, if your credit line is $50,000, you’re not paying interest on the full $50,000 unless you max out your credit line. Which you don’t want to do. This is where a small business loan differs from credit, and can actually help your business credit score.
One of the factors in determining your credit score, both personal and business, is how heavily you utilize your available credit. Having $50,000 in credit doesn’t make it a good idea to run a $49,000 balance.
Most credit agencies want to see a credit utilization not higher than 30%, in some cases not higher than 20 percent. On a $50,000 credit line, that means carrying no more than a $10,000 to $15,000 balance. Keep in mind that your credit utilization is measured in the aggregate. Let’s say you have two cards, for a total of $50,000 in credit; your total outstanding balance is measured against your total credit available. If you maxed out your $10,000 credit line, but only have a $2000 balance on your business card with a $40,000 limit, your utilization is seen as $12,000 of a $50,000 credit line. Even so, maxing out a credit card never looks good.
Getting a short term business loan helps you manage your credit utilization by giving you another source of funding so you don’t have to max out your balances. If you’re looking for capital for expansion, that’s not something you want to finance with your credit cards. First, credit lines are typically more expensive than a small business loan. It also would likely require either too high credit utilization or making more credit card applications to increase your maximum available. Taking either option will hurt your credit scores.
You do want a business credit card because it’s a great way to establish early credit with a positive payment history. But don’t make it your primary source of special funding. Credit is great for recurring, fixed expenses – buying supplies, paying utilities. Not for meeting payroll in a crunch or investing in new equipment.
If you’re in a cash flow crunch and you start using more of your available credit, getting a small business loan to pay them off will help improve your credit score by reducing their utilization, ending a string of late or delinquent credit card payments, and making your repayment costs on the money lower than your credit card interest rate.
- Get better tradeline terms and history on your report.
One of the factors used in business credit scoring is your payment terms. If you have a number of non-standard, short cycle payment terms with lenders or vendors, this is seen an indicator of low trust.
A 30-day net is usually pretty standard for most businesses. If you have vendor who will only sell to you on a 15-day net, or with pre-payment or deposit required, that tells agencies that your vendors don’t consider you a reliable payer. On the other hand, having vendors who sell to you on 60- or 90-day net shows they have more confidence in you. But this varies by industry. If it’s standard in your industry for vendors to sell on 60-day net terms, but you only get 30-day net; then your variance from industry standard hurts your score.
If the tradelines on your business credit report don’t look good, you can use a small business loan to start repairing them. Make sure these vendors report your payments to the right credit agencies. Your report will start to show a positive payment history.
That positive payment history will also help you negotiate better, or least more industry standard, terms with your vendor. Some of the business reporting agencies, like Dun & Bradstreet, won’t even generate a report for you without you showing a minimum number of vendor tradelines. If you have only bad tradeline history and terms, then use a small business loan to turn those around. Improving your tradelines will improve your business credit score.
Good Business Credit is Good Business
Using small business loans wisely to improve your credit scores makes paying for money in the future much cheaper. When you have a good business credit score, you also have access to considerably more credit than you do with a personal loan. This makes a good business credit score a financial asset in its own right. If your business is currently held back by bad credit, you can change that with the right small business loan.