If you've considered applying for a small business loan to grow your business and pay for your business expenses, you may be wondering why your personal credit is so important - and how lenders use it when you apply for small business loans. Let's talk about the basics of how a lender uses your personal credit profile when deciding if they will approve or deny your small business loan applications. Lenders determine your creditworthiness using five major factors from the credit report:
- (1)Payment history, collections, and public records
- (2) Outstanding balances carried on accounts
- (3) Length of credit history
- (4) Types of credit, and
- (5) Number of inquiries
If you've ever been denied for a small business loan then you may remember that frustrating denial letter you received in the mail. By the way, according to a recent Biz2Credit survey, the big banks are only approving about 17% of the applications they receive from small business owners so don't be discouraged if you're part of the 83% who got the equivalent of a Heisman stiff arm. However, if we don't learn from our failures then we are doomed to repeat them. You should probably know the lender must disclose to you the details of the credit report used in the underwriting decision and tell you why your loan was denied. This is actually one of the main reasons why Fair Isaac, the makers of the FICO scoring model which has a dominant market share in the credit scoring space, decided to include Reason Codes with their commercial lender credit reports. The Reason Codes can be copied and pasted into the lender denial letters to ensure lender compliance.
Here are a few tips on how to build your personal credit profile based on these 5 factors so you can increase your chances of being approved for a small business loan.
1.) Payment history, collections, and public records
35% of your FICO score is based on these items. If you make timely payments you can avoid negatively affecting your credit history and score. Making timely payments will also make you look good in the eyes of lenders and will increase your chances of being approved for small business loans.
2) Outstanding balances carried on revolving accounts
30% of your FICO score is based on what's called utilization, the total balances carried on the revolving accounts that are reporting to your personal credit report. This includes most personal credit cards as well as some of the business credit cards that automatically report to your personal credit report every month. Capital One is an example of a lender who, unfortunately, treats your business credit cards exactly the same as your personal credit cards by reporting the activity every month to your personal credit report. Bottom line? Keep your balances as low as possible. Utilization is also a key component of most credit card underwriting models so if your aggregate utilization is high then don't expect to have much luck with that credit card application you filled out.
3) Length of credit history
15% of your FICO score is determined by the length of your credit history. Therefore the sooner you start building credit, the better. If you are married then a wise credit strategy is to make your spouse an authorized user on your older credit card accounts - as long as there's not late payments and the balances are not excessive. If you are not married then maybe Uncle Louie could help you here. While there has been much talk about the newer scoring models having the intelligence to know if your authorized user account is "legit" or not, there's nothing wrong with your spouse or a family member adding you to their credit card as an authorized user. Read more about authorized users here, from credit guru John Ulzheimer.
4) Types of credit
10% of your credit score is determined by the types of credit accounts you have. A mixture of loans and lines of credit is best. Lenders like to see that you have the ability to maintain a mixture of different types of debt over a long period of time.
5) Number of inquiries
10% of your FICO credit score is determined by your numbers of inquiries in the last 12 months. If you want to apply for a small business loan, it's best to keep your inquiries to a minimum. Otherwise you will likely have some explaining to do. Keep in mind that you can pull your credit online through a credit monitoring service and avoid the hard pull or new inquiry that could ding your scores.
If you read between the lines at the top you'll realize that denial letters are often just a list of reasons why your credit scores are not higher. If you keep these credit factors in mind and do everything you can to protect, preserve, and improve your credit profile then you will find that your chances of getting approved for a small business loan will increase measurably.