Perhaps the biggest obstacle between a business owner and getting that small business loan is bad credit. While a business may have its own credit score, nearly all lenders are going to look at the personal credit score of a small business owner. As a small business owner, you are your business.
So many small business owners personally finance their businesses – whether it’s emptying retirement accounts, taking out a second mortgage, or maxing out credit cards. It’s no wonder lenders assess what sort of credit risk the business owner is. With traditional bank lenders, small business owners are coming up short. The big banks approve just 23.1% of business loan applications. What constitutes bad credit? Personal credit scores are almost universally represented by your FICO Score, which runs on a scale of 300-850. There are five generally recognized categories of FICO scores, ranging from excellent (750+) to bad (below 600). Poor credit ranks slightly above bad credit, but some organizations don’t bother with this category. They work off a four-tier personal credit score categorization: excellent, good, fair, and bad, with bad credit being any score below 630.
According to 2015 data, the average FICO score for an American is 695, which ranks in the fair to good credit categories. Yet nearly a third (30%) of Americans with a credit rating have a score below 601. So having a bad credit score doesn’t make anyone an outlier.
Having bad credit can bar you from a bank loan. Alternative lenders can guide you on how to get a small business loan with bad credit. They provide different options. Depending on the exact type of small business loan or financing instrument they offer, the alternative business lenders place more emphasis on your recent and current operating history and cash flow than your credit score.
TERM VARIABLES ON BAD CREDIT BUSINESS LOANS
Having options with alternative business lenders doesn’t mean your credit won’t impact the terms of the small business loan you get. It will. A lower credit score is an indicator that responsible lenders can’t ignore. In order to make these business loans available to owners with bad credit, they need to mitigate their risk. Business loans with these rougher terms are what we call “bad credit business loans.”
There are four business loan terms that can each be adjusted to account for the increased risk presented by a bad credit score:
- Dollar amount loaned (principle)
- Repayment period
- Factor/Interest rate (APR)
- Scope of collateral required (if any)
So a construction contractor with a good personal credit score (let’s say the American average: 695), could possibly get a $100,000 business loan with a one to two-year repayment term at somewhere between 10 to 15% interest, depending on what type of collateral he’s willing to put up. If that same construction contractor has a personal credit score of 575, he’s not going to get this deal.
Instead, our construction contractor will have to take things both more quickly and more slowly. More slowly because his small business loan will likely be for a lower amount. Say he needs $100,000 to buy new equipment. He may have to stagger those purchases, and buy some equipment with a smaller business loan first. Successfully pay that first loan off and then be able to take another business loan – perhaps at slightly better terms if the first one was repaid on time. Having to start with a low principle amount doesn’t just protect the lender, but the borrower as well. Baby steps. Don’t get your business too far under water that you can never come up for air.
The time – or term – of the business loan is where the construction contractor may have to take things more quickly. People with higher credit scores will get more time to repay a business loan since they’re considered better risks. In contrast, someone with a bad credit score will have to repay their entire loan on a shorter time frame. So instead of having two years to repay a $100,000 business loan, the terms on bad credit business loans may offer $25,000 principle to be repaid in 12 months at a higher factor rate.
The value and type of collateral provided to secure the business loan can affect these other terms. Having a co-signer on the loan who has strong personal credit can be helpful, but difficult to secure. You may have a lot of equity in your house, but I can’t recommend you risk your family’s home for a business loan. You can offer business assets, like equipment, invoices, or inventory to secure business financing, which can make more sense. I’ll get into this more below.
For now, understand that you can get a small business loan with bad credit, but be realistic about the kinds of terms you can get and afford.
FACTORS – OTHER THAN CREDIT – THAT IMPACT SMALL BUSINESS LOAN TERMS
While a small business owner’s credit score is an important factor when setting terms of a business loan, it’s not the only factor. In fact, an alternative business lender may give some of these factors greater weight. We’ll typically also look at:
- Length of time in business
- Annual revenue
- Cash on hand
- Available collateral
Just like with the business loan terms, these variables can balance each other out. A restaurant that’s been operating less than two years with an annual revenue of $100,000 may qualify for better terms than a restaurant operating for three years with an annual revenue of $50,000.
Alternative business lenders look at operational history and annual revenue as key indicators of a business owner’s, and their business’s, reliability. Annual revenue and length of time in business are strong signs that the business will continue throughout the life of the loan.
This is why length of operations is so important. Say two businesses both have modest annual revenues of $75,000. One business just hit its first year anniversary, while the other has been operating for three slow and steady years. The business owner of the three-year old business will probably be able to get a bad credit business loan on better terms than the younger business.
In addition to assessing whether a company can show that it’s an acceptable risk regarding repaying the entire small business loan, lenders also consider the ability and likelihood of a business being able to pay the monthly payment, which impacts what ranges of principle, term, and interest rates are acceptable. This makes cash on hand and cash flow important factors.
If your business has a low number of invoices that pay on a long cycle, as is typical with construction contractors, then you may have different monthly payment terms than a restaurant that shows a fairly stable flow of predictable monthly revenue. So the construction contractor may get a higher interest, low monthly payment with quarterly or loan-end balloon payments. The restaurant owner, with the same bad credit score, may get a lower interest rate with higher monthly payments.
When you’re preparing to look for a small business loan, there isn’t a lot you can do in the near-term about your annual revenue or number of years in business. You can address the cash on hand and collateral issue though.
BUSINESS LOAN OPTIONS AVAILABLE TO OWNERS WITH BAD CREDIT
There are two general business loan options for someone with bad credit: a term business loan, which I’ve been talking about at length already, and a business line of credit. A term business loan is just that – it exists for a fixed term. For most bad credit business loans, the term will be relatively short as compared to other types of small business loans. A line of credit is revolving, meaning as long as you have space on your credit limit, you keep “re-borrowing” what you need within that limit.
Because of their different natures, a term loan probably makes more sense for a small business that’s looking for a cash infusion to make a big change to their business. This could be some sort of physical expansion, either new equipment or growing space. It might mean buying additional inventory or taking advantage of a different growth opportunity. A revolving line of credit is best for managing cash flow or gaining access to additional working capital when needed.
If you’re looking for a bad credit business loan, most banks will want to review at least a few years of past bank and financial statements. A term business loan lender is going to focus on whether you can make the monthly payments on any deal. So your demonstrable cash flow will set the boundaries on the terms of your business loan. It’s also common for banks to require a borrower to have more cash on hand than she’s looking to borrow.
Alternative online platforms take a slightly different approach. They’ll still want to see some operating history and financial statements, but perhaps not three years’ worth. For some platforms and lenders, your most recent collection of statements for the past six months will do. In some cases, the lender may require direct access to the business owner’s accounting system. This might filter out some businesses that aren’t using a compatible online financial and accounting system.
Like a bank, an alternative business lender will look at cash flow to set business loan terms. The lender may look at actual annual deposits, rather than revenue, to determine how much to loan. These lenders may also use automated repayment methods, like ACH, to keep interest rates lower (although they’ll still be higher than if the borrower had good credit).
Any small business owner who wants a bad credit business loan will need to get its financial documents in order, and be able to show an accurate and realistic plan of how their use of the money will result in business growth and ensure timely repayment.
Setting up a business line of credit is more difficult for people with bad credit. If your credit is below 600, then this may not be an option. If you’re sitting in the low 600s and just need to working capital, certain types of business credit lines may be available.
For example, that construction contractor who has high dollars, yet slow paid invoices may be able to get an invoice line of credit. In this case, the lender will be looking more closely at the credit-worthiness of your clients, not you. If you’re a business that needs additional inventory, you can get an inventory line of credit to finance the purchase, with the inventory acting as collateral on the credit line.
One of the benefits of a business line of credit is that you don’t need to take out the full amount available. If you get a business loan of $15,000, you’re paying interest on that full $15,000 from day one. If you get a business line of credit worth $15,000, but only need $5000 today, you’re only paying interest on that $5000 until you tap into more of your credit.
BAD CREDIT DOESN’T MEAN BAD BUSINESS
This goes both ways. Having bad personal credit doesn’t mean you’re running a bad business. It just means the cost of financing your business will be more expensive and may have to move more slowly.
On the flipside, don’t confuse the notion that because there are solid business loan options for people with bad credit that these options are also available for businesses running in the red. Running a business that’s currently unprofitable is a very different circumstance that requires different options.
But a business owner that can show a solid operating history doesn’t have to let their bad personal credit hold them or their business back. There are options to get a small business loan with bad credit.