Credit score is the number one factor for obtaining a small business loan. It’s the first thing most financial institutions look at when determining approval. Other factors, like annual revenue and time in business, are also very important but won’t play as big of a role as personal credit score. Without excellent credit, it is nearly impossible to be approved for a high borrowing amount accompanied by convenient terms and a low interest rate.
Luckily, achieving and maintaining an excellent personal credit score isn’t difficult at all. In this guide, we’ll go over the best practices for improving personal credit, which activities affect personal credit, and the relationship between personal credit score and business credit score.
What Is The Best Possible Credit Score?
The highest possible personal credit score is 850. As astronomical as that number may seem, it is entirely attainable if you adhere to just a few basic principles. But depending on your needs, your credit score might not have to be anywhere near 850. In fact, you may be able to obtain the right business loan for you with just a “good” credit score.
Still, there’s no downside to trying to get your credit score as close to perfect as possible. Before explaining how to do that, let’s clarify what a personal credit score actually represents:
What Does A Personal Credit Score Represent?
Most small business owners have numerous credit scores, such as their VantageScore and business credit score.
But when it comes to small business loan requirements, financial institutions are referring to your personal credit score. By definition, a personal credit score is a numerical representation of your ability to repay debt. Credit cards, mortgages, student loans, and business loans are examples of debts that make up your personal credit score.
Why Do Institutions Care So Much About Personal Credit?
At first, it doesn’t seem fair for institutions to put so much worth into an applicant’s personal credit score. After all, you are applying for a business loan, not a personal loan. But small business owners are in charge of their business’s finances. You could even argue that much like the aforementioned examples of debt, a small business is just another personal financial venture.
Based on that logic, an applicant’s track record with personal debts is indeed an accurate indicator of how he or she will handle a small business loan. Small business owners are not like the stereotypical scientist or artist: They aren’t amazing at their jobs yet a total mess in other aspects of their lives. A small business owner who can’t manage credit card debt will probably have the same luck with business loan payments.
Every institution has its own requirements and underwriting process. Some institutions frequently work with borrowers with poor or little credit history. Their highest borrowing amounts and most advantageous terms, however, are only available for borrowers with good credit at the very least.
Why Is Credit Score Used To Assess Risk?
Financial institutions take a risk every time they approve a business loan: not being paid back on time. The business owner, on the contrary, is dealing with several risks. Will the investment produce the desired returns? Will the repayments impact cash flow?
But most institutions do not care about these other risks. Being paid back on time is their only concern. The business owner is responsible for making those payments. So, in order to gauge the likelihood of the business owner making timely payments, the institution assesses the applicant’s current track record with this responsibility.
Also, most institutions’ requirements for time in business and annual revenue aren’t difficult to meet. Excellent personal credit, on the other hand, is a much rarer find. The higher your personal credit score, the more financial institutions you have to choose from.
How Is Your Credit Score Calculated?
The highest possible credit score is 850, and the lowest is 300.
- Excellent: 740-850
- Good: 680-739
- Fair: 580-679
- Poor: 500-679
- High Risk/Untouchable: 499 and under
The three main credit bureaus (TransUnion, Equifax, and Experian) calculate credit score via an algorithm created by the Fair Isaac Corporation in the 1960s. If that name sounds familiar, it’s because it inspired another commonly used term for your credit score: your “FICO” (Fair Isaac Co.) score.
The components of the algorithm are not public. So, outside of the three bureaus, no one knows exactly how a credit score is calculated.
What we do know is the criteria the bureaus factor into their calculations. It is broken down into five categories, from the most important (top) to the least (bottom):
- Payment history
- Amounts owed
- Length of credit history
- New credit
- Credit mix
Basic Principles For An Excellent Credit Score
The path to excellent credit is surprisingly simple. Someone with excellent credit makes payments on time and takes on numerous types of debt but not too much.
If this is so easy, why do countless business owners suffer from poor credit? The short answer is they knew the rules but didn’t know how to stick to them. In other words, they didn’t know how to prevent themselves from straying from the path to excellent credit.
Here are the general guidelines for avoiding this situation:
Pay Your Bills On Time
This can’t be stressed enough. Payment history is the number one factor for credit score, so all monthly payments should be made in full and on time. Maintaining this habit automatically gives you good credit, even if you’re only managing one or a few types of debt. If you can make payments on time, you have already taken the biggest step towards an excellent credit score.
Missing just one payment, however, can cost you dearly. The total effect of a missed or late payment depends on your existing credit score and how late the payment was made. For example, if someone with a high credit score makes a payment 30 days late, the individual’s credit score could drop by over 100 points.
Since payment history is so important, measures should be taken to ensure you never miss a payment. A good starting point is setting up automatic deposits with as many creditors as possible. Remembering to make payments might not be difficult now, but what about when you take on more debt?
Another way to ensure timely payments is to pay all of your bills on time, not just credit payments. Paying rent and utility bills on time gets you into the habit of paying promptly in general. Hence, you will be more likely to pay creditors on time as well.
Know That Default Isn’t The Only Option
Business owners are often forced to fall behind on loan payments due to a sudden crisis. The money that would normally be used to make payments is instead salvaged to keep the business alive. When you are scrambling to save your business, your credit score probably isn’t the first thing on your mind.
As a result, the business owner defaults on the loan and his or her credit score plummets. In the past, this might have been the only option. Today, certain institutions may be willing to help you pay off your existing debts, even when your finances aren’t in the best shape.
A default on your credit report will make it extremely difficult to rebuild your credit score and get another business loan. So, instead of immediately choosing to default amid a sudden crisis, contact financial institutions that specialize in helping borrowers pay off existing debts.
Steer Clear Of Bankruptcy, Collections, and Foreclosures
Filing for bankruptcy can reportedly lower your credit score by over 100 points. If it’s a Chapter 13 bankruptcy, it will stay on your credit report for a decade, compared to the usual seven years for all other negative credit information.
In addition to bankruptcies, legal problems like judgments, collections and foreclosures can ruin your credit score and are even harder to recover from than a default. While you can certainly rebuild your credit score afterwards, achieving a score within the “Excellent” range may be close to impossible.
Use The Right Amount Of Credit
The “Amounts Owed” category refers to the amount of debt you are currently paying back. But that doesn’t just come down to your total balance. A clearer indicator of where you stand in this category is your credit utilization ratio, or how much credit you use compared to how much credit is available to you.
A credit utilization ratio below 30% is said to be most conducive to an excellent credit score. This shows that you have plenty of credit available and are only using a little of it. Going too close to 0%, though, can actually damage your credit. It is therefore better to use credit from time to time rather than almost never.
Maintain Old Accounts
The third category, “Length of Credit History,” refers to the average age of your accounts and how often you use them. As long as you make payments on time, a longer credit history gives you a higher credit score. Longer credit history shows financial institutions that you have more experience managing debt. But you won’t reap the benefits of a longer credit history unless you use that credit, even if it’s just once in a while.
Sometimes, an institution will advise taking out a small business loan primarily to build credit history. Just a few months’ worth of timely payments can significantly raise a borrower’s credit score and open up the many benefits of good credit. Accomplishing the same thing with a new credit card would take longer and you wouldn’t be growing your business in the process.
Don’t Take On Unnecessary Debt
Applying for a series of new credit cards or loans within a relatively short time frame will temporarily hurt your credit score. Someone with little credit history might do this in an attempt to quickly establish a substantial track record of timely payments. But every new account is viewed as a new risk. And since there’s such little time between the opening of the different accounts, there’s less activity to prove that the borrower is capable of paying them off.
Institutions will also make a hard credit pull before issuing approval, which temporarily decreases your score by around five points. That adds up with every application. So, if you do apply for multiple loans within a short time frame, it should only be because you truly need the money, not because you’re trying to raise your credit score.
Manage Different Types Of Credit
There are two types of credit: revolving and installment. The first type refers to credit that can be accessed in any amount and at any time, like a credit card or business line of credit. Installments are lump sums that are paid back in fixed amounts on a monthly basis, like business term loans or student loans.
Higher credit scores are typically rewarded for those who can manage both types and show a good “credit mix.” Institutions like to see that you are not afraid to take on more debt you can clearly afford.
Credit Your Credit Report Periodically
Unfortunately, credit report inaccuracies are not uncommon. Just one inaccuracy could cost you over a hundred points if it is not corrected as quickly as possible. The only way to catch these inaccuracies is to monitor your credit report on a regular basis.
Everyone is legally entitled to one free credit report from each of the three credit bureaus each year. This allows you to track your score three times a year by requesting one report from a different bureau every four months. But since inaccuracies are so common, it’s perfectly understandable to check your credit report more often. Requesting a credit report from one of the bureaus will not affect your credit score. It just takes more time than accessing a free report.
What Is Your Business Credit Score?
While personal credit score represents an individual’s credit activity, business credit score represents credit activity that is tied to the business itself. Much like your personal credit score, the number one rule for maintaining a great business credit score is to pay your business’s bills on time.
How Is Business Credit Score Calculated?
Business credit is calculated by the three major credit bureaus: Dun & Bradstreet, Experian, and Equifax. The most relevant score, however, is calculated by Dun & Bradstreet and is a number between 0 and 100.
Here are the primary criteria for business credit score:
- Credit utilization ratio
- Payment history
- Length of credit history
- Public records, i.e. bankruptcies and judgments
- Company size
- Risk factors in your industry
How Can I Build Business Credit?
Business credit comes from paying your bills and (possibly) loan payments on time. Therefore, the key to raising your business credit score is working with the right business partners and taking on more business partners as your business grows.
Here are some ways to accomplish both goals:
Register as Independent Company
Registering your business as an LLC or corporation separates your business’s debts from your personal credit. Your business can now take on more debt without affecting your personal credit score, which would certainly plummet from the amount of debt carried by the average small business.
This separation will also be extremely helpful in the event of a sudden crisis. Your inability to pay your bills would not affect your personal credit score. So, you’d still be able to qualify for a highly advantageous small business loan.
Pay Business Expenses with Business Credit Card
Paying your business’s bills on time will do nothing for your business credit if the payments come from a personal account. These payments must come from an account in your business’s name or a business credit card. Using a personal credit card for this purpose can damage your personal credit score, which is why the requirements for business credit cards have loosened as of late.
Make Sure Suppliers Report Payment History
In order for payments to affect business credit, your supplier must report your payment history to the major credit bureaus. Some suppliers do not voluntarily report payment histories, so it’s important to ask potential partners about this before making a commitment.
Ask Potential Lenders The Same Question
Payments to certain financial institutions may or may not affect your business credit score. Some institutions may only help you build business credit with certain products. This goes for personal credit score, too. Payment histories for certain business loans may not be reported to the three bureaus. For example, payments for a business line of credit or merchant cash advance are usually not reported.
Yes, It’s Really That Easy
In summary, building and maintaining great personal and business credit comes down to three fundamentals: Paying your bills on time, not taking on too much debt, and not using too much or too little credit.
No, doing this won’t automatically produce a perfect 850 credit score. But you don’t need perfect credit to access the most desirable business financing products, like SBA Loans and traditional business term loans from banks. A personal credit score in the high 700s should be enough to qualify. As long as you follow the basics and regularly check for inaccuracies, that’s exactly what your personal credit score will look like.