Are Small Business Loan Approvals Based on Personal Credit?
The answer is fairly simple, if you’re a small business owner, your personal credit will affect your ability to get approved for a business loan.
The magnitude of your personal credit’s effect, however, depends on other factors too. The most significant of these factors include:
- The type of lender, loan, and collateral
- The terms and amount of your loan
- Your business’s debt repayment history and capacity to repay
- Your business’s capital structure
- Current economic conditions
These five factors, along with your credit score, are what traditional lenders use to determine the overall risk of lending to you.
If these five factors show that lending to you isn’t risky, your personal credit score is less important. However, if you don’t score well on these five factors, your personal credit becomes more significant.
Still, even if your personal credit doesn’t stop you from getting approved, it can make the business loan cost more expensive. So, if there’s room for improvement in your credit score, it’s certainly worth pursuing.
To help you tackle this goal, we’ll review how you can boost your personal credit prior to applying for a business loan.
How to Improve Your Personal Credit Score to Get Approved for a Small Business Loan:
1. Understand How Personal Credit Scores Are Calculated
By understanding the numbers behind your personal credit history, you can get an idea of how to improve your score.
The following is a breakdown of how the most common credit score, the FICO Score, is calculated:
- Amounts owed: 30 percent
- Payment history: 35 percent
- Length of credit history: 15 percent
- Credit mix: 10 percent
- New credit: 10 percent
The percentages listed above represent how important each category is in determining your credit score.
2. Make Your Payments On Time and In Full
As you saw in the previous section, the most important factor affecting your personal credit is your payment history. Therefore, if you make a habit of paying your debts on time and in full, you’ll have a better credit history.
As a result, you’ll be more likely to get approved for a business loan or other financing options, such as a merchant cash advance, business line of credit, and equipment financing.
If you’ve had a history of missing or late payments, all is not lost if you start making your full payments by their due dates. Therefore, if you stay committed to making debt payments on-time, you can bring your credit score back up and in turn improve your overall finances.
Of course, the more missing or late payments you have, the longer it takes to improve your credit score. If you have significant debt, you’ll need to focus on paying it off responsibly over a notable period of time before you’ll see any tangible improvements to your credit score.
3. Formulate a Long-Term Plan
Let’s say your credit mix, payment history, new credit, and length of credit history are all good. The only problem is you only have one credit card with a limit of $5000. Due to this, you use 60 to 80 percent of your limit each month.
Because you’re using almost all of your credit each month, your credit score will inevitably suffer. To fix this, you could either request to increase your credit limit or apply for an additional business credit card.
If you get a new credit card, you’ll have access to more credit, but your score may decrease because you added new credit. However, as time goes by, that new credit will age, your amounts owed will decrease, and due to this your credit score will likely increase.
All this to say, it’s important to look at your credit improvement efforts in the long-term. The more time you give yourself, the more options you have to improve your score.
4. Check Your Personal Credit Report for Errors
In a study by the Federal Trade Commission (FTC), 27 percent of participants found at least one error on their credit report. To check your report for errors, you’ll need to request your report from each of the three main credit bureaus, Equifax, Experian, and TransUnion.
If you find an error, here are the steps you should take to fix it:
- Gather documentation and write a letter disputing the error
- Send your letter and supporting documentation to the credit bureau
- Contact the lender who reported the incorrect information
For more on fixing credit reporting errors, USA.gov provides useful information on their Credit Reports and Scores page.
5. Don’t Drag Out Your Loan Shopping
When you shop for a small business loan, alternative and online lenders conduct what’s called a hard inquiry on your credit. This means that the business lender has requested your credit file so they can evaluate your creditworthiness. Hard inquiries appear on your business credit report and negatively affect your credit score for a short time.
If you’re shopping for a small business loan, hard inquiries are unavoidable. Therefore, the key isn’t to avoid but to limit the impact of hard inquiries. To accomplish this, you should make sure they occur infrequently.
When you take time to research loans, do so only over a short, focused timeframe. This helps because the credit bureaus recognize that you’re submitting multiple business loan applications to compare rates. Due to this, the bureaus treat it as a single hard inquiry.
If you compare interest rates and other factors over a longer period of time, you’ll have multiple hard inquiries, which will hurt your credit score and overall business finances.
We suggest focusing on your business loan search, instead of casually looking for financing. You should be confident in your need for funding and work to get approved. If you aren’t certain you require additional funding, you may be better off waiting until you have a clear financing need.
Conclusion: Your Personal Credit Matters When Pursuing Business Loans
We’ve addressed how personal credit affects your business loan approval status, but what about the opposite? That is, does taking out a business loan affect your personal credit?
As you may have guessed, it depends on your business’s financial situation. If you’ve personally guaranteed a business loan, or if you’re a sole proprietor, your business loan will affect your personal credit.
In addition, although many reputable business credit card providers don’t report to consumer credit bureaus, they will if you miss a payment.
Ultimately, your best bet is to pay your bills on time, keep your balances low, and educate yourself. The more you know about how personal and business credit scores work, the more empowered you will be to take action.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.