How Small Business Loan Underwriting Works
By understanding how the process works for small business owners, you’ll gain insight into what a lender is looking for. It’ll also help you prepare your finances to improve your chances of approval.
In this blog post, we’re going to explain how small business loan underwriting works.
The Goal of Business Loan Underwriting
When underwriting a business loan, the lender’s goal is to determine your ability and willingness to pay. To make this determination, underwriters evaluate many metrics, each of which are related to one of the following five C’s:
- Character: reflected by the applicant’s credit history and reputation.
- Capacity: the applicant’s revenue, other income, debt-to-income ratio, and debt-to-asset ratio.
- Capital: the applicant’s net worth and equity in the business.
- Collateral: An asset that can back the loan
- Conditions: the purpose of the loan, the amount involved, and prevailing interest rates.
The five C’s are a simple, high-level way to think about what lenders look at when they’re underwriting a small business loan.
However, small business loan underwriting is not a uniform process. One lender may emphasize capacity over character or vice versa. Another might overlook a lack of collateral if a borrower meets their capital requirements, and so on.
Put simply, underwriters don’t all evaluate each of the five C’s in the same way.
What Underwriters Look For When Evaluating a Business:
As you can see, most of the five C’s are evaluated with multiple metrics. For example, your revenue and debt-to-income ratio both play a role in determining your capacity to repay a loan.
This is an important point because not all underwriters use the same metrics to evaluate your loan application. Plus, some metrics affect the terms of your loan, like the amount, while others determine whether you’re approved at all.
So, to understand underwriting, you need a basic familiarity with the following metrics and how underwriters use them:
1. Annual and Monthly Revenue
Your monthly and/or annual revenue plays a central role in determining how large of a loan you’ll qualify for. Generally speaking, lenders will not approve your application for a loan amount greater than 10 percent of your annual revenue. Some underwriters may use monthly revenue instead, but the principles remain the same.
2. Debt-to-income Ratio
Your debt-to-income ratio (DTI) compares how much you owe each month to how much you earn. Typically, underwriters want to see a DTI below 36 percent. All else being equal, the lower the percentage, the better your chance of getting approved with favorable terms.
3. Debt-to-asset Ratio
Your debt-to-asset ratio compares how much you owe to the value of the assets you own. The more assets you own combined with the less debt you have, the better. For unsecured loans (loans without collateral), your debt-to-asset ratio is particularly important. This is because, if you default, the lenders can recoup their losses by going after your personal assets.
4. Loan-to-value Ratio
The loan-to-value ratio only applies to secured loans. This is because loan-to-value compares the amount of your loan to the value of your collateral. The higher the value of your collateral relative to your loan amount, the easier it is for a lender to recoup their losses. For this reason, the lower your loan-to-value ratio, the better the chance is you’ll be approved for the loan.
5. Loan-to-net-worth ratio
Loan-to-net-worth is a ratio that compares your net worth to your loan amount. All else being equal, the larger your net worth, the larger the loan amount an underwriter will approve you for. Of course, as is the case with most other metrics, not all lenders require a certain loan-to-net-worth ratio.
6. Personal Equity
Personal equity is the amount of money you’ve invested into the business or project you plan to finance. This is a helpful measure for underwriters because it gives them an indication of how willing you are to pay. The more money you have invested in a project, the less likely you are to let your loan default if you can help it.
Red Flags in the Business Loan Underwriting Process
For underwriters, numbers and metrics are important, but they don’t paint the entire picture. This is because certain circumstances indicate to underwriters that a borrower is especially risky.
These circumstances include:
- Past bankruptcies
- Unpaid judgments
- Major revenue drops
- A criminal background
- Ongoing evictions or late rent payments
Even if you have low debt, high net worth, and plenty of revenue and personal equity, you can get rejected for these issues. If you’re facing any of these circumstances, be upfront about your situation. Underwriters will uncover these things anyway and if it seems you’re trying to hide them, your application will be rejected.
Conclusion: Learn How to Apply the Principles of Underwriting
Understanding the underwriting process is one of the best steps you can take to be an informed borrower. So, congratulations on taking the time to learn the basics before you start your application process.
Just remember, this is a general overview of how this process goes for most small business loans. The underwriting process will look different if you pursue alternative financing, even though the principles are the same. Still, with the basics under your belt, you’re well equipped to navigate any kind of underwriting process.
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.