Many businesses, both large and small, rely on borrowed capital to fuel growth and fund other business initiatives. In other words, borrowing is just part of the equation. This means small business owners need to understand how their credit impacts their ability to borrow more than the average consumer looking to purchase a house or buy a new car.
Every small business owner in the United States basically has two credit profiles. Their personal credit score and business credit history. In order to understand how credit impacts a business owner’s ability to access borrowed capital, you need to understand both.
Why understanding personal credit is important
For most small business owners on Main Street, your personal credit history is going to be a part of every business creditworthiness conversation you have with a lender. What’s more, one of the least appreciated or understood parts of owning and running a successful business is the importance of building and maintaining a credit profile that makes borrowing easier and provides options for financing that a poor profile doesn’t.
We witnessed this in April and May of this year as many small businesses were turned away from needed Paycheck Protection Program (PPP) funds offered by the SBA because they couldn’t meet the standard of “acceptable credit” required by the SBA and their lenders.
A strong credit profile is more important than ever now, as many small business lenders tighten their qualification requirements and some have even stepped away from small business lending for the time being. This has happened before following the financial crisis in 2008 and is a pattern that I’ve seen happen following other recessions. Meaning, the business owners that are best able to understand, improve, and leverage their credit are the most likely to access the capital they need to grow—or maybe even stay afloat during the current health and economic challenges we face right now.
How is personal credit determined
Most of the personal credit reporting agencies base their credit scores on the FICO score. Although their scores may vary slightly, the basic formula they use to calculate their scores is similar. FICO measures your score based upon these five data points:
1. Payment history (35%)
This is the single most important metric and where you can have the most lasting impact on your credit score. If you meet your credit obligations in a timely manner, in other words, if you make your mortgage payments, auto payments, and credit card payments on time every month, it is the most powerful way to build (or strengthen) your personal score.
2. Amount owed (30%)
The amount of credit you use when compared to the amount of credit you have available is what we’re talking about here. If you can keep your credit utilization (the industry term for this percentage) down below 30% it will positively impact your credit score.
The lower you can keep this percentage the better. For example, if you have $10,000 in credit available on your personal credit cards and you regularly run a balance between $8,000 and $10,000 (even if you make timely payments every month) it will reflect negatively on your FICO score. A $3,000 or less balance (30%) is preferred and if you can keep your credit utilization around $1,000 (10%), even better.
3. Length of credit history (15%)
Lenders like to see a track record. Basically, they are trying to determine what you will do in the future based upon what you’ve done in the past. In other words, the longer your credit history the better. So, that credit card you seldom use, but you’ve had for 10 or 15 years actually helps your personal score.
You may have a newer card that has better rewards points that you use more frequently, but it might make sense to occasionally buy a tank of gas or a dinner at a restaurant to keep it active and reflected on your credit report. In other words, from the perspective of building a strong personal credit score, avoid the temptation to cut up your credit cards and close accounts—even if you don’t use them very often.
4. Credit mix (10%)
Creditors like to see a mix of credit on your report; which is reflected in your score. A mortgage, an auto loan, and a credit card are reflected more positively than say, simply an auto loan.
5. New credit inquiries (10%)
Every time you apply for new credit there will be a slight impact on your personal credit score. In the normal course of life, this ding will be very slight, but you should be aware of it. The credit bureaus also treat shopping for an auto loan or a mortgage much differently than applying for every department store credit card available to you. Typically, it’s nothing to be too concerned about, but it is important to be aware of and shouldn’t prevent you from applying for the credit you need.
Now that you know how your personal credit score is calculated, you might be asking yourself, “What is a good credit score?”
What is a good personal credit score?
Although there might be differences from agency to agency, most rank personal credit scores like this (I’ve included the potential impact to a small business loan application):
|800+||Excellent||Long credit history with no late payments or accounts that were ever in collections. This rating will receive the lowest rates with the best lenders.|
|750 — 800||Very Good||Likely to have a shorter credit history, but is still devoid of late payments or accounts that were ever in collections. This rating typically qualifies for low-interest rates with the best lenders.|
|700 — 750||Good||There are no recent late payments or accounts in collections. Typically, you should be able to qualify for a good lender, but at a slightly higher rate.|
|650 — 700||Fair||There are some recent late payments or accounts in collections, but everything is currently in good standings. This rating might exclude some bank loans, but you will typically qualify for a decent rate from most alternative lenders.|
|600 —650||Bad||There are late-payments and the account owner is struggling with accounts in collections. Historically, the same is true. Some lenders may approve this rating for loans, but they will be at higher interest rates.|
|Below 600||Very Bad||The account owner is in the middle of collections and has frequently had trouble in the past. You may be able to get a Merchant Cash Advance or Cash Flow Loan, but the rates will be high.|
5 tips to improve your personal credit score
Whether you’re looking at a small business loan, an auto loan, or a new mortgage, lenders are trying to determine if you have the means to service debt and whether you are likely to make all your periodic payments. These five tips are not only credit best practices, I have personally seen the positive results in my own personal credit score.
1. Know your score
It’s human nature to positively influence the things you pay the most attention to, this is particularly true for your personal credit score. Regularly monitoring your personal score is the first step. I’ve personally had a relationship with Experian for many years and have watched my personal credit score improve—primarily because I’m paying attention to it every month (a monthly review is not too frequent). The first step is to know your score and although I’ve paid a small fee every month to Experian for the service, there are a number of services like Nav, that offer credit monitoring for free.
2. Use credit wisely
You might think this is an oversimplification, but it isn’t. Avoid the temptation to access all the credit you have available simply because you can. A good rule of thumb is to keep the ratio of credit you use compared to the credit you have available to below 30%. I am very conscious of every time I use a credit card, for example, and how it will impact my ratio—and I have been rewarded for it with a higher score.
3. Don’t jump around
Transferring balances from one credit card to another won’t help your score and is considered a very transparent gimmick that could actually hurt your personal credit score.
4. Make timely payments
This probably goes without saying but this is the single most important thing you can do to improve your score. I’ve set up automatic payments to make sure I’m never late on things like my mortgage or auto payments.
5. There are no quick fixes or shortcuts to improving your score
This is one time when slow and steady really does win the race. You will be surprised at how these good credit practices can make a difference over six months or a year.
What do you need to know about business credit?
Your personal score and your business credit history work together to show a potential lender that you have a track record of meeting your personal and business financial obligations. Your business credit history is really a collection of scores, rather than one score like your personal FICO score, and can vary from business credit bureau to business credit bureau. With that in mind, here are some of the things that are included in the average business credit report:
General information about your company
Some of the information used in your profile is available from the public record. Information like annual revenue, the industry you’re in, how long you’ve been in business, and the status of any current liens or judgments are all data that eventually wind up in your credit profile. If the information on file with the state where you do business is inaccurate or out of date, it can hurt your profile. For example, something as simple as a wrong SIC (Standard Industry Classification) code could put your business in a higher-risk category and make it harder for you to qualify for a small business loan.
Because it’s not uncommon to see mistakes in the public record, creating a relationship with the business credit bureaus is important because it enables you to make sure all the information they have about your company is accurate. Fortunately, the credit bureaus are motivated to make sure the data they have about you and your business is as correct and current as possible, so they are motivated to correct legitimate errors.
How timely do you pay your vendors and suppliers?
Trade credit is an important source of credit to all businesses but is an invaluable way for new businesses to start building their credit profile. Dun & Bradstreet has been monitoring business credit the longest and focuses on this aspect of your credit profile, but the others also consider how timely you pay your vendors and suppliers.
D&B provides potential creditors with several reports (like their 100 point PAYDEX® report) that not only offer insight into how far beyond agreed-upon terms you pay your invoices, they also provide predictive insight in how likely you will remain current in the future, whether or not your business is under stress, and how healthy your business is financially. Experian and Equifax provide similar data about your business and rank past performance to predict what you will do in the future.
How timely do you meet your other credit obligations?
If you use a business credit card, have a business line of credit, or other small business loan; the business credit bureaus use your payment history as part of your profile. Equifax for example takes the data from the Small Business Finance Exchange (SBFE), which is credit data collected by the largest small business lenders in the United States as part of their report, which details how business owners make credit card and other business loan payments. Because this data is a direct reflection of how businesses interact with large business lenders, many banks use this report to evaluate your business’ creditworthiness.
Similarly, Experian looks at the number of credit transactions, outstanding balances, payment habits, how much of your available credit you use, and the details of any current liens, judgments, or bankruptcies to evaluate your credit. Experian, like Dun & Bradstreet, provides a risk score for small businesses on a scale from 0 to 100—or High and Medium Risk to Good and Excellent Credit depending upon where your profile falls on their scale.
Don’t be afraid to use your business credit, The wise use of business credit over time helps build a strong credit profile as you establish credit accounts, pay them off, and stay current with suppliers. Making the trade credit accounts you establish early in the life of your business can be very important down the road—provided you’ve been able to maintain a good credit history with your suppliers. The same is true for other business credit accounts.
6 tips to build or improve your business credit profile
1. Find out what your profile looks like today
Because your business credit profile doesn’t include a universal credit score, you will likely need to contact more than one of the bureaus. For example, while your Dun & Bradstreet profile includes much of the same type of information as Experian or Equifax, they might weigh the value of some parts of the data differently than the others. As a result, it makes sense to have an understanding of what the different bureaus are reporting about your business.
2. Look for errors
An error as simple as the misclassification of your industry can negatively impact your ability to borrow if that industry is considered a bigger risk than another. Additionally, if the information about your business is incomplete and you don’t update your profile with current information, the bureaus will be forced to make a “best guess” about the information that is lacking.
3. Use business credit for business purposes and personal credit for personal expenses
While it’s very tempting (and many business owners do it) to use your personal credit cards or other personal credit for business expenses, it’s not a good idea and doesn’t build your business credit profile. 35 percent of your personal credit score is based upon the amount of your available credit compared to what you currently use. The higher credit balances often required for business expenses can pull down your personal credit score—ultimately handicapping your ability to qualify for business credit with some lenders in the long term. For many young, or early-stage, businesses, using your personal credit sometimes can’t be avoided, but as soon as possible, you should separate the two.
4. Make sure your vendors report your good credit history
As mentioned above, your vendors aren’t required to report your timely payments, but you want them to. While it’s important to build good relationships with your individual creditors, if they don’t report, it won’t build a history ultimately making it more challenging to create new credit relationships with new creditors. If your current creditors don’t report to the business credit bureaus, encourage them to do so. And, when looking for new vendors, it’s important enough to ask.
5. Establish business credit accounts
One of the easiest ways for an early-stage business owner to start building a business credit profile is to reach out to current suppliers and ask about establishing a credit account. In those early years it can be difficult to get a small business loan, but those vendor accounts will help you build a strong credit profile early, making it much easier a year or two down the road.
6. Meet your business credit obligations in a timely manner
The single most powerful tip for building a strong business credit profile is to pay your bills on time. That includes your vendors, any loans you might have, your utilities, and your business taxes. Consistently paying late can take a serious toll on your profile. It doesn’t take long before the occasional late payment starts to negatively impact your ability to qualify for a loan. Conversely, your good credit behavior will over time build a stronger credit profile.
The importance of your credit profile
You can’t afford to ignore your personal credit score or your business credit profile because they work together to help answer three important questions every lender wants answered (even if they don’t ask them this way).
- Can you repay a loan? Do you have the revenue and cash flow to make periodic loan payments?
- Will you repay a loan? Do you have a track record of meeting your financial obligations that implies you will do so in the future?
- Will you continue to make timely periodic payments should something unexpected happen?
If you can answer these questions successfully it will improve the odds of a successful small business loan or business credit card search. Managing your credit profile is an important part of answering these questions. A strong credit profile is no guarantee you’ll get the financing you’re looking for, but it will give you options a weaker profile will not. And, it will make it easier for a lender to say “Yes” to your application.