When you set out to find the first loan for your small business, you’ll probably have many questions but few answers. In fact, while researching loan options, your query list might grow even longer.
The following article answers several frequently asked questions about small business loans and will help you make the best decision:
How much should you borrow?
Although this question sounds simple, you’ll need to consider cash flow and other specifics. Some owners only want to borrow “a little extra,” but remember you do have to pay off this loan and the interest that comes with it! For now, put aside the vision of a brand new Mercedes “for business use” and calculate how much money you actually require for your specific business purposes.
Will your business have the cash flow to make timely loan payments while still covering the rest of your daily operations?
You can figure this out quite simply with a few numbers from your business financial statements. Calculate a ratio of how many times your monthly cash flow can cover your monthly loan payment– this is known as a debt service coverage ratio. Simply divide your monthly total cash flow by the proposed monthly loan payment to get your ratio.
For example, let’s say your company’s monthly cash flow is $1,000 with potential loan payments of $300 per month. Divide $1,000 by $300 to get a ratio of 3.33. This means your monthly cash flow can cover your loan payment more than three times, which makes lenders very happy. Lenders usually require a minimum debt coverage of 1.35 to include a small financial cushion for unexpected expenses.
You can also use this formula before loan shopping to figure out how much of a loan payment you can comfortably handle. A 2x times ratio or higher, like our example of 3.33, is your safest bet.
What if your small company doesn’t have an established credit rating?
This concern affects many first-time small business borrowers. In reality, lenders focus much more on the credit score you’ve achieved in your personal life. Why?
Lenders know that it’s the company owner, not the company itself, who makes the loan payments. Your personal credit history can be very telling in terms of how you’ll handle prompt repayment of a business loan.
Spend time before loan shopping to review your personal credit score. Compare scores from several different sources, because FICO scores get calculated differently based upon each rating agency’s preferences and various other factors. For example, you can get your scores for each of the three main credit bureaus from online sites such as MyFICO.com. After getting a feel for your average score, you’ll have a better sense of the types of interest rates available to you for small business loans.
- An average score above 700 is very good. This should set you up for just about any small business program with access to the lowest interest rates.
- Scores in the 650 to 699 range are still considered good. You can probably still get preferred interest rates in this range.
- However, once scores dip below 650, you’ll find the small business loans available to you are limited.
Help! What if my personal credit score isn’t great?
OK, so you haven’t exactly made all of your payments on time in the past, leaving you with a less-than ideal credit score. Don’t worry– you still have options:
Make sure you pay all of your payments on time, each and every month. Doing this for 6 – 12 months before applying for a loan can give your credit score a big boost. And keep in mind: Credit bureaus consider several factors when calculating your scores. Some carry more weight than others.
Another factor that weighs heavily into your credit score is your debt usage. If you have just a few credit cards, with balances maxed out, credit agencies assume you rely too heavily on your credit and cannot afford to pay it off each month. One quick fix: apply for another credit account.
Although this seems counter-intuitive, it gives you more available debt capacity. As long as you don’t charge up any of this debt capacity, you have automatically improved your ratio of available credit to the amount of debt already used. Of course, it’s also important to pay down your existing debt.
Work towards using less than 30 percent of your total debt capacity. For example, if your credit cards have a total limit of $10,000 combined, make sure to keep no more than $3,000 of combined debt on them in any given month.
Review your credit reports for inaccurate reporting. This can help improve your scores without requiring additional money for debt payoff. Request a copy of your credit report from each of the three big credit bureaus and review it for errors. If you find something, you need to dispute the inaccurate record in writing, directly to the credit agency.
If you order your credit report from one of the three big credit bureaus, TransUnion, Experian or Equifax, you can see how many late payments each credit company has recorded on your record in the past. This might help reveal some poor payment habits and tell you where to make improvements going forward.
Several companies now offer credit monitoring for a monthly fee. This gives you regular insights into your credit scores, which actually fluctuate based on monthly activity. You may find it easier to stay on top of payments and other credit-building activities if you can see your monthly progress.
What else do banks need to know?
In addition to your credit score, banks consider several other factors to determine whether you’d make a good borrowing candidate. Lenders give each of these factors as much weight as your credit score when making lending decisions.
How long you’ve been in business. Studies have shown that 95% of small businesses fail within the first five years. If you’ve only been in business a year, lenders may not think you’re ready to handle a small business loan. After logging two or more years of experience with your business venture, lenders might find you a much more appealing prospect for a loan.
How much annual revenue your company generates. Your company must bring in enough cash to cover loan payments along with all of the other standard expenses that come with an ongoing business operation. In fact, lenders want to see a loan payment that amounts to 12% or less of gross annual revenue. This is an important indicator of how much cash lenders want you to have to cover other expenses and still make your loan payments on time each month without issue.
Your company’s bank account balance is one last important barometer of cash flow and creditworthiness. Lenders might request your bank statements to verify cash flow and an average bank account balance over time. If your company generates a good amount of revenue but uses it up so quickly that nothing extra makes it into the bank, this indicates that you might have trouble making your loan payments consistently. Banks like to see at least two months’ worth of expenses covered with cash savings in your bank account in case something unexpected happens.