It’s more than just your credit score
As a business owner, you know how important it is to have access to extra capital when you need it. Maybe you want to add some new equipment to your practice, make building renovations, or even buy the building you’ve been leasing. To do it, you need purchasing power. For most practice owners, the best way to get more of it is through a loan.
The first question many business owners ask is if they should use business credit or personal credit when applying for a loan. “At Cain Watters, we advise the vast majority of our clients to use personal credit for business loans,” says Bradley Blasingame, CPA and FinancialPlanner at Cain Watters & Associates. The reasons are two-fold. First, personal credit history is automated, meaning scores are automatically generated in real-time based on preset factors (outlined later in this article). Business credit, on the other hand, is a manual process. Measured on a scale from 0 to 100, the primary factors lowering business credit are complaints, collections, liens, judgments and bankruptcies. Because these are manually entered, they can often be erroneous and time-consuming to clear up. The second reason is tax savings. Leveraging personal credit allows practice owners to take advantage of tax deductions on accumulated interest starting in the current tax year.
With these two factors in mind, it’s no wonder why keeping a good personal credit history is crucial to increasing your purchasing power. “The operative term here is credit history, not credit score,” says Bradley. “Your credit score is only one of the factors lenders look at in evaluating your overall credit history.” To make a true determination of your credit-worthiness, Bradley says lenders look at a combination of three factors:
- Credit Score
- Reputation and Goodwill
Factor One: Credit Score
Your credit score is exactly what you think it is. That magical, mystical FICO rating assigned to you by each of the three credit bureaus: Experian, Equifax and TransUnion. FICO scores are calculated by evaluating data in five categories using a weighted scale to determine a final score:
- 35% Payment History
- 30% Debt-to-Credit Ratio
- 15% Credit History Length
- 10% New Credit
- 10% Overall Credit Mix
Even though each bureau weighs and calculates FICO scores a little differently, in general, a score around 600-669 is considered fair, 670 to 739 is good, 740 to 799 is very good and 800 to 850 is exceptional.
If you have a credit score in the fair range, getting a loan for the amount you want might be difficult. In the good range, you will probably get the loan you want, but maybe not the lowest interest rate. Borrowers in the very good to exceptional range typically get the best rates available.
“The credit score is important because lenders use it as a starting point for evaluating credit-worthiness,” says Bradley. “However, for business owners, liquidity is also a major player.”
Factor Two: Liquidity
Liquidity is the amount of cash on hand that practice owners can easily access. For example, money in both business and personal checking/savings accounts is liquid. Monies locked in retirement accounts or tied up in real estate are not liquid.
Lenders typically want to see about 10% liquidity before approving a loan. So if you’re looking to borrow $250,000, the bank will want to see at least $25,000 in accessible cash.
“Liquidity is something practice owners definitely want to think about well in advance of initiating the loan process,” said Bradley. “Pre-planning to make sure there are enough liquid assets available is key to a smooth loan experience.”
Factor Three: Reputation and Goodwill
The final factor is a bit more ambiguous but no less important—especially for business owners. Reputation is how the company is viewed based on both positive and negative reviews from customers, clients, vendors, etc. Goodwill is an asset of the company relating to its net-positive reputation. The value of the goodwill asset can be measured by the difference in take-over price paid compared to fair-market value. Loss of goodwill can be measured by a reduction in profits over a given time period. Goodwill also extends to a company’s intellectual property and their corresponding values.
Taken together, reputation and goodwill give lenders a look at the health of a company beyond the profit and loss statements. While there is really no set formula, banks will typically look at the following factors:
- Number of trade experiences
- Balances outstanding
- Payment habits
- Credit utilization
- Number of credit inquiries
- Trends over time for all of the above
The key takeaway here is the emphasis on trends. Is there an increased trend in slow payment of obligations? Are practice owners paying down credit card balances or just paying the minimum? Is the business able to operate during stressful times or does it consistently need to take out more credit?
According to Bradley, paying off balances is especially important for businesses operating with an existing line of credit because lenders want to see that a company does not need to rely on credit to operate.
“CWA recommends having open lines of credit to all our clients,” says Bradley. “That said, you do need to be paying it off so there is a period of dormancy or zero balance. In a lender’s eyes, maxed out credit is going to be more important than a good credit score.”
Preparation is the Key
Bradley recommends practice owners plan as far as possible in advance of needing funds so any issues affecting credit-worthiness can be addressed.
Checking all three credit reports annually at a free resource like freecreditreport.com can help owners uncover any irregularities. Sometimes it’s a simple oversight. For example, a student loan transfers banks without you realizing it. Suddenly it looks like you are missing payments. Catching and correcting these issues right away will go a long way in improving your credit history before it becomes an issue with a lender.
If you do find anything inaccurate in your report, there are two ways to resolve it. If the issue is with an entity you recognize like your bank, call them and get it resolved. If you don’t recognize it, Bradley counsels clients to call a credit repair service, who can freeze the report until it gets resolved.
“It can take several months to pay down credit, gather liquidity or clear something up on your credit report, and you could miss out on that business opportunity you wanted to pursue right away,” says Bradley. “That’s why it’s important to plan in advance with a professional tax advisor or financial planner.”
As always, Cain Watters & Associates is available to make the planning process simple and seamless. Talk to a CWA Advisor on how to help increase your practice’s purchasing power before the next big opportunity comes your way.