When small business owners apply for loans, often lenders ask for both personal finance and business information. So, who gets assessed in a small business loan application, the business or the owner? The answer is simple: both.
In many ways, small business loans have similar characteristics as personal loans. Small businesses are typically managed and funded by the owner. Therefore, the personal credit quality of the owner partially drives the credit risk of the business. Beyond looking at the personal credit score of the business owner, lenders look for other metrics:
- Recent delinquencies, foreclosures, tax liens or bankruptcies;
- Personal debt as a % of income;
- Annual household income
- Net worth
The metrics above highlight the owner’s ability to pay-off a business loan. In an illustrative example, a small business makes $200,000 a year with no debt on the balance sheet. However, the sole owner has over $500,000 in personal debt with no other sources of income, savings and property to pay-off his personal obligations. In this case, despite the high cash flows of the business, the risky credit profile of the owner makes it difficult to finance the underlying business.
Similar to personal loans, small business loans require a personal guarantee from the owner. A personal guarantee ensures owners have “skin in the game.” With a personal guarantee, owners treat a business loan similar to a personal loan and as a result are more incentivized to meet their payments on-time.
While lenders overweigh business fundamentals compared to personal finances, small business owners must get their personal finances in order to minimize debt costs and maximize debt capacity of their business. Below are some thresholds a business owner should meet or exceed to improve their chances of accessing affordable business financing:
- Personal Credit Score above 600 (although Camino Financial works with owners with scores as low as 500)
- No outstanding delinquencies, foreclosures, tax liens or bankruptcies in the past 12-24 months
- Personal debt as a % of annual income below 50%
- Borrow less than 75% of credit lines available (don’t max out your credit cards)
- Net worth based on quantifiable assets such as property or cash savings