For the vast majority of small business owners in the United States, your personal credit score will likely always be part of the equation whenever you apply for a small business loan. While some lenders, like traditional bankers, may weight the score heavier than online lenders or other non-traditional lenders, they all want to know your score. Here are three reasons why a personal credit score could be misleading metric when assessing the credit-worthiness of a small business:
1. Your personal credit score is about how you pay your personal bills, not your business obligations: The personal credit score, or FICO® score, was originally designed to evaluate borrowers applying for a long-term home mortgage or auto loan. “Mortgage lending credit is heavily tilted toward viewing someone as a consumer,” writes Charles Green, a 35-year small business lending veteran in a recent book written for bankers: Banker’s Guide to New Small Business Finance. “Such orientation is different in many respects than business lending, but FICO scores are cited as the reason to decline business loan applications. These borrowers are often punished by credit denial or higher interest rates due to what some might objectively define as a lender’s misplaced reliance on the FICO score beyond what analytics may merit.”
In other words, how consumers use credit and how businesses access credit are not the same and it might not make sense to rely exclusively on a personal credit score as a reason to deny access to business credit. And while your personal credit score is a great measure of how you have historically paid your credit card bills, your home mortgage, your cell phone bills, or an auto loan, it doesn’t reflect the profitability of your business or how much money you have in your business bank account.
Using a business owner’s personal credit score as a go-no-go measure of business creditworthiness may be easier for lenders, but it also makes it easier to ignore other metrics that could help predict whether or not a business owner would repay a loan on time and could potentially lure some lenders into a false sense of security regarding the quality of the loans they do approve.
2. Lenders need to include other metrics to get a more complete picture: While personal credit score should likely be part of the equation, if a lender automatically rejects a loan application because of a low personal credit score, they may be rejecting an otherwise good small business loan customer for the wrong reason. Other metrics that would complete the picture might include things like annual revenue, monthly cash flow, and other financial metrics for the business. Lenders may also consider other business attributes and non-financial information like industry andmarket position.
And, there are circumstances when a very successful business owner might have a less-than-perfect personal credit score. This can be particularly true with young businesses that are compelled to rely on personal credit to fund business initiatives because they are denied business credit. For example, maxing out a personal credit card (because you can’t get business financing) to pay for monthly business expenses could negatively impact your personal credit score (a high debt to credit ratio) even if you pay off the balance at the end of every payment period—basically creating a vicious cycle where a business owner’s personal credit score goes down making it even harder to get a small business loan. The continued reliance on personal credit may push the credit score down even further.
3. Great personal credit doesn’t always equate to a healthy, thriving business: All businesses are not the same. Some are more successful (profitable) than others—regardless of the business owners personal credit score. If lenders fail to go any further than a review of a potential borrower’s personal credit score, it’s possible they may approve a loan to a floundering business owner with a great personal credit score while rejecting the loan application of a business owner with a thriving and profitable business because the owner has a blemished personal score.
Personal credit scores can be misleading because without the whole picture, including information like business profitability and cash flow, it’s too easy for loan officers to make bad decisions about which loans to approve and which loans to reject.
It’s unlikely that the benefit of maintaining a good personal credit score will ever go away for small business owners. Nevertheless, as a small business owner you need to be prepared to tell the whole story. While many lenders heavily rely on your personal credit score when making loan decisions, there are others that will dig a little deeper to learn more about your business when you apply for a loan. If you’re prepared to talk about the overall health of your small business it will likely improve the odds of success when you apply. But if you can’t, it makes it easier for lenders to rely on a metric (personal credit score) that doesn’t paint the full picture.
All any lender evaluating your business loan request really wants to know is that you are able to repay a loan and that you will repay a loan. Your personal credit score is just one lens to help them look into the future by reviewing the past.