The Top 5 Business Loan Qualifications to Be Aware Of
When it comes to determining how to qualify for a business loan, tapping into that resourcefulness will set you apart. This is because, if you’re willing to work, you can take steps to increase your chances of qualifying.
Of course, how you can improve your chances depends on your financial track record and the type of business you own. Some entrepreneurs are best served by building their credit history. Others benefit more from choosing an alternative kind of loan structure, term, or type. Regardless, applying for a loan requires research and preparation.
Although qualifications for a business loan will depend on the lender, it’s important to educate yourself on typical requirements. In this blog post, you’ll learn about common small business loan qualifications so that you can improve your chances of getting approved. By fully understanding these qualifications, you can complete your loan application and receive the funds you need to succeed!
Understand The Five C’s of Credit
Most small business lenders use a system called the five C’s to gauge the risk of lending to a potential borrower. By weighing these five characteristics of the borrower and the loan, lenders determine the chance of default. Lenders approve, deny, and (in part) set interest rates based on the five Cs.
Investopedia explains the five Cs as follows:
1. Credit: This is reflected by the applicant’s credit history. If you have bad credit, you should work to improve your score prior to applying.
2. Capacity: This dictates the applicant’s debt-to-income ratio. If an applicant has significant debt, the lender won’t be confident in their ability to repay a loan.
3. Capital: A business’s capital is the amount of money they have. If the business generates low cash flow, they may not be able to afford loan payments.
4. Collateral: Collateral is an asset that can back the loan. If a business owner isn’t a strong candidate, they can use collateral to secure their loan.
5. Conditions: The purpose of the loan, the amount involved, and prevailing interest rates.
In short, anything you can do to improve on any of the five C’s will help you qualify for a small business loan. In the next five sections, we’ll explain how to improve on each of the five C’s.
1. Credit: Look for Opportunities to Improve Your Credit Rating
If you know how your credit score is calculated, it’s much easier to adjust your behavior so you can improve it.
According to FICO, your credit score is calculated based on five categories, each of which is weighted differently. These categories, their weight in your credit score calculation, and how to improve them, are in the chart below:
|Category||Weight||How to improve|
|Payment history||35 percent||Make all debt payments on time and in full. Avoid carrying a balance on credit cards.|
|Amounts owed||30 percent||Avoid using all (or a large portion) of your available credit. Pay down your balances when possible.|
|Length of credit history||15 percent||Establish your credit score by using a few accounts for a long time instead of many new accounts.|
|New credit||10 percent||If possible, don’t open several new accounts in a short time.|
|Credit mix||10 percent||Do your best to pay off all your various types of credit accounts on time and in full.|
By reviewing your credit report regularly, you can stay on top of your credit score and ensure that it is high enough to qualify for funding.
2. Capacity: Improve Your Debt-to-Income Ratio
If your debt-to-income ratio is near 36 percent (or higher), reducing it will greatly increase your chances of qualifying for additional financing. To reduce this ratio, you can do any one or more of the following:
1. First, you should increase your monthly debt payments to lower your debt levels quickly.
2. Next, adjust your spending behavior to prevent taking on more debt. Avoid taking on additional loans for the time being.
3. Lastly, delay purchases so you can make larger down payments.
Also, remember that your spending behavior is the key factor in reducing your debt-to-income ratio. To help improve your spending habits, set up a simple spreadsheet to track your ratio each month. Seeing concrete progress will help keep you motivated, and increase the likelihood that a reputable online lender will provide you with a business loan in the future.
3. Capital: Save Up and Make a Larger Down Payment
If the small business loan you’re seeking requires a down payment, offer to make the largest one you can. This improves your chances of qualifying for your loan in two ways. First, it reduces the total amount that you borrow, which reduces the total downside risk for the lender.
Second, making a large down payment shows the lender that you have skin in the game. This is important because borrowers with a lot of money committed are motivated not to default.
Also, even if you aren’t making a down payment, business loan lenders prefer borrowers with more capital to those with less. Therefore, if you can, save up before you apply for a small business loan. The more money you have in savings, the better able you are to pay off—and qualify for—a loan.
4. Collateral: Secure Your Loan with an Asset
Pledging a valuable asset, such as inventory, equipment, or property, makes qualifying for a loan far easier. This is because, if the borrower defaults, the business lender takes possession of the collateral. Once the lender owns the collateral, they can sell it, which helps them recoup their losses.
Ideally, your lender will have no reason to take your collateral. However, it helps reduce the lender’s downside risk which makes qualifying easier for you. In many cases, pledging collateral can also reduce the total cost of your loan.
In many cases, you’ll be asked to sign a personal guarantee. By signing this document, you’ll pledge to repay your business loan. If you can’t pay off the loan balance, you’ll have to pay it off using your personal assets instead.
5. Conditions: Determine Your Goals and Identify Your Funding Options
Business loans come in many forms. In addition to term loans and business lines of credit from traditional business banks, there are other business funding options such as:
1. Equipment and inventory Loans
2. Merchant cash advances
4. Accounts receivable financing
5. Bridge financing
6. Small Business Administration (SBA) Loans
7. Business Credit Cards
Each of these loan options is structured differently, so their qualification criteria vary significantly.
For example, accounts receivable financing involves selling your invoices at a discount in exchange for a cash advance. Since your invoices are what provides the lender value, the likelihood that your customers will pay is what the lender is concerned with.
That means the creditworthiness of your customers, rather than yours, is the most important qualification criteria for accounts receivable financing.
Before pursuing a financing option, review your business plan and funding needs. This will help you determine which loan option will be the best fit for your small business.
Conclusion: Understand the Qualifications for a Business Loan Before Applying
Unfortunately, many entrepreneurs don’t think about financing until they urgently need it. If you think ahead, though, you’ll have more opportunities to improve your chances to qualify. In addition, you’ll open up even more business financing opportunities than you’d have if you didn’t prepare.
The best part is that you don’t have to do everything we suggested above all at once in order to secure a business loan. Start where you think you can make the biggest impact with the least burden. Then, build from there, and before you know it you’ll be in a position to finance your business the way you want.
Editor’s Note: This post was updated for accuracy and comprehensiveness in November 2021.
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.