For a small business owner, the need to maintain a good personal credit score never goes away. It doesn’t really matter how much information is available about your business, lenders also like to look at the personal financial history of the person behind the business. What’s more, because early-stage (less than a year) companies haven’t yet established a track record or a comprehensive business credit score, traditional lenders like banks and credit unions will primarily rely on your personal credit score as an indication of you and your new business’ creditworthiness.
Your personal credit score is really a reflection of past payment behavior for your household. There are many who don’t believe it’s a good indicator of how your business will meet its obligations. Nevertheless, because most traditional lenders largely rely on your personal credit score when considering whether or not you qualify for a small business loan, it’s important to understand your personal credit score and how it impacts loan decisions.
Your Personal Credit Score
The early days of credit reporting were largely made up of local merchants working together to keep track of the creditworthiness of their shared customers. With the passage of the Fair Credit Reporting Act in 1970, the Federal Government enacted standards to improve the quality of credit reporting.
The FICO Score was first introduced in 1989 as a formula for banks and other lenders to evaluate the creditworthiness of a consumer. Your FICO score is based upon data collected by the consumer credit bureaus. The three biggest are Experian, TransUnion, and Equifax. All three of the major bureaus use the same scale from 300 to 850 to rank your credit, but the scores are rarely exactly the same.
That said, the formula for calculating the score is pretty straightforward:
- 35% Payment History: Late payments, bankruptcy, judgments, settlements, charge-offs, repossessions, and liens will all reduce your score.
- 30% Amounts Owed: There are several specific metrics including debt to credit limit ratio, the number of accounts with balances, the amount owed across different types of accounts, and the amount paid down on installment loans.
- 15% Length of Credit History: The two metrics that matter most are the average age of the accounts on your report and the age of the oldest account. Because the FICO score is trying to predict future creditworthiness based upon past performance, the longer (or older) the file the better.
- 10% Type of Credit Used: Your credit score will benefit if you can demonstrate your ability to manage different types of credit—revolving, installment, and mortgage, for example.
- 10% New Credit: Every ‘hard’ inquiry on your credit has the potential to reduce your score. Shopping rates for a mortgage, an auto loan, or a student loan will not typically hurt your score, but applying for credit cards or other revolving loans could reduce your score. According to Experian, these inquiries will likely be on your report for a couple of years but have no impact on your score after the first year.
What’s in a Credit Report and How Does it Translate Into a Credit Score?
The credit bureaus use the FICO formula to score the information they collect about you. All three of the bureaus capture your personal information like name, date of birth, address, employment, etc. They will also list a summary of any information that has been reported to them by your creditors. Anything in the public record like judgments or bankruptcy will be reported in the three credit reports. Any time you apply for additional credit will also be on all three reports.
Additionally, as a result of additions made to the Fair Credit Reporting Act in 1996, you are allowed to add a 100-word statement to any of the reports that include an item you dispute but aren’t removed because it was verified by a creditor. Sometimes there may be extenuating circumstances (like a divorce, a prolonged illness, or job loss) that could explain a negative credit score. This gives you the opportunity to make sure potential creditors see that information.
There are some minor differences in the way the three bureaus look at your personal credit information, for example, Experian includes data regarding whether or not you pay your rent on time, Equifax separates your open and closed accounts, and TransUnion dives deeper into your employment data. The primary differences can be attributed to the fact they are competitors and some creditors might report to one bureau and not the others. The differences in the data produce slightly different scores.
Despite the differences, when a small business lender looks at your personal credit score, here’s what they see:
Below 579: Bad
There is some financing available for borrowers with this type of credit score, but it’s considered a high-risk loan and will likely come with higher interest rates. It’s very unlikely this borrower would be able to qualify for a traditional bank loan or a loan from the SBA.
Although there are financing options available, it is unlikely this borrower would find success at the bank. And, a borrower with this credit score should expect to pay a high-interest rate. This score is also considered a higher-risk credit score.
This is considered a moderate-risk credit score. A small business loan is very possible, but will likely not come with the lowest interest rates. If your personal credit score falls within this range, expect to pay a moderate to high-interest rate. A 660 credit score is the bottom threshold the SBA will typically consider.
This is considered a good score and many in the U.S. fall within this range. A borrower with this type of score can expect to see more approvals and better interest rates.
720-799: Very Good
If your credit score falls within this range you are considered a low-risk borrower and will be able to find a loan just about anywhere. A borrower with this credit score should expect to be offered excellent interest rates along with other possible perks.
Above 800: Excellent
If your personal credit score is above 800 you can expect lenders to roll out the red carpet. Borrowers with this credit score will be offered the best interest rates and the most favorable terms.
6 Tips to Improve Your Credit Score
With focused effort, a less-than-perfect credit score can be improved over time:
- Know your score—Federal law requires you have free access to your credit report once per year. All three of the major credit reporting agencies offer credit-monitoring services for a fairly nominal fee, and annualcreditreport.com is the government's authorized source for your free annual credit report.
- Use credit wisely—This may sound like an oversimplification, but it’s important to avoid the temptation to regularly access all your available credit. For example, even if you pay off the balance with every statement, maxing out your personal credit cards will negatively impact your score. If the goal is to improve your credit score, try to keep your credit usage to around 15 percent of your available credit limit.
- Don’t jump around—Transferring balances from one credit account to another doesn’t do anything to help improve your score. In fact, it’s considered a very transparent gimmick that might actually hurt your credit score.
- Make payments on time—This is likely another obvious suggestion. Because 35 percent of your credit score is calculated by how timely you make payments and meet your financial obligations it’s something you can’t ignore. Even one late payment can lower your score.
- Don’t apply for credit you don’t need—Because credit inquiries reduce your score, applying for unneeded credit doesn’t make sense if you are trying to improve your score.
- Slow and steady wins the race—There really is no shortcut to improving your credit score. However, a focused effort over six months to a year can positively move the needle. Sometimes significantly. Alternatively, missing a payment or two will likely pull your credit down significantly very quickly.
Even though your personal credit score is not a very accurate measure of how your business will meet its financial obligations, the need to maintain a good personal credit score is vital for every small business owner. Most traditional lenders rely heavily on your personal credit score as well as evaluate your business credit rating when they consider your loan application - regardless of how long your small business has been around.