The percentage of total bank business loans that go to small businesses is in a steady decline, from over 50% in 1995, to under 30% in 2012. While it is harder than ever for small businesses to get a bank loan, it’s not impossible. Here are three of the primary hurdles you will encounter when trying to get a bank loan, and how to overcome them.
Hurdle #1: Knowing how much to ask for
Banks have a formula for determining how much they will lend to you. The formula is called the debt service ratio. Knowing your debt service ratio before you go into the bank will help you figure out how much to ask for, and make it more likely that you will be approved for a loan.
Here’s how to calculate your debt service ratio:
Debt Service Ratio = Monthly Free Cash Flow / Monthly Loan Payment
Your monthly free cash flow is the money that is left over each month, when all expenses are paid.
If you have $10,000 in free cash flow, and your monthly loan payment is $5,000, then your debt service ratio is 2. If your loan payment is $7,500, then your debt service ratio drops to 1.33. Banks are unlikely to make a loan where the debt service ratio is less than 1.25.
Before asking for a loan, figure out how much the bank is likely to lend to you based on your debt service ratio. Here is a calculator that you can use to calculate your loan payments. Current rates on small business commercial loans will be somewhere between 8 to 13%.
Also, keep in mind that banks will generally not lend to companies with less than two years of operating history. If you have been in business for less than two years then consider another method for obtaining money such as a personal P2P loan or ROBS.
Hurdle #2: Your personal credit score
In order to borrow money from a bank, small business owners generally have to sign a personal guarantee. A personal guarantee states that if the business is not able to pay the loan, they are personally liable. This means that the bank is likely to place as much emphasis on your personal credit score as they are the creditworthiness of your business.
Before going and asking for a loan, make sure that your personal credit score is above 700. If it is not above 700, here are the steps to take:
- Dispute any errors on your credit report.
- Keep your debt to credit ratio below 30%. This means that for every $1 of available credit, you should be using less than $0.30.
- The number of cards you have a balance on is also a factor, so pay off cards with small balances, and just use one primary card.
- Obviously, pay your bills on time.
Hurdle #3: Collateral for the loan
Banks are going to want collateral for the loan, even if you have a good debt to service ratio and personal credit score. Not only are they going to want collateral, but they are going to want the right type of collateral. If you are a commercial real estate developer, then the land and buildings you own are examples of the type of collateral that banks like. Both are easy to value and sell if you are not able to make payments on your loan.
If you sell sock puppets on the other hand, then the bank will not likely want your sock puppet inventory as collateral. Sock puppets are hard to value, and if your business is not able to sell them so you can make your loan payments, the bank is not likely to be able to sell them either.
If you don’t have the right type of collateral, then focus on getting an SBA loan. SBA loans are commercial loans that are backed by the Small Business Administration. Because the SBA will pay some or all of the loan if you are unable to, lenders are willing to make SBA loans to borrowers without collateral. All the other requirements are the same however, you still need to be in business for at least 2 years, have a good debt service ratio, and a good personal credit score.
For more on SBA loans see the Fit Small Business Ultimate Guide To SBA Loans.