As a small business owner, there will likely come a time when you need to apply for financing. Yes, you know about credit checks, but what are the other factors a lender considers when assessing whether or not to take you on as a borrower?
Read on as we take a look at the five C’s of credit, the system lenders use to determine the creditworthiness of potential borrowers looking for a business loan.
First up is character, and this includes the aforementioned credit check. Lending institutions will pull your credit report and credit score to assess your trustworthiness and reputation. Do you have a history of repaying other debts? Have you ever declared bankruptcy or had a lien against you? Lenders want to give money to those who have proven responsible in the past. If you’re looking to get financing from a local or community bank, stop by and speak with the bankers. Building an in-person relationship can make them more likely to lend to you, as long as your credit report and score don’t raise any major red flags.
Capacity is measured by looking at your company’s recurring debts in comparison to its income. Lenders will determine your debt to income ratio (DTI) to gauge the likelihood of your ability to pay back the loan. Companies with a low DTI are more likely to have the money on hand to make loan payments, and that in turn will make them a more desirable candidate for a loan.
Lenders will also look at the amount of capital a borrower is willing to put in when asking for a loan. The larger the contribution upfront from you, the more “skin in the game” you have as a borrower, making the lender feel secure in the fact that you’ll be less likely to default on payments. If you’ve already invested your own capital in your business before turning to a lender for a term loan, equipment financing, or revolving credit, you’ll be a stronger applicant than if you were looking for the lender to carry a greater piece of the financial burden.
If you don’t have “skin in the game” in the form of capital, lenders might look for you to use items to pledge as security against a loan. Collateral serves as a backup if you’re unable to pay your loan for whatever reason, and it’s most common with equipment financing, car loans, or mortgages, where the item you’re purchasing with the financing becomes the collateral for the loan. One of your first steps as a business owner should be to establish a proper business structure—like an S-Corp or LLC—before searching for financing, to ensure that your personal assets can’t be taken as collateral if you experience issues in repaying a business loan.
Conditions of the loan—like interest rate, amount of principal, and how the lender intends to use the money—are all assessed by the lender when determining whether or not to work with a borrower. While those things are within your control, lenders will also look at external conditions—including macroeconomic issues and what’s going on in your specific industry—that could affect your business’s income.
Of course, there’s not much you can do about the global economy, but you can be strategic about when you choose to apply for a loan. Perhaps counterintuitively, it’s best to apply for loans when your business is strong because lenders are more likely to take you on as a borrower when conditions are good and repayment is likely.
Being aware of the factors that lenders consider when determining who to work with is a key step in ensuring you’ll secure the financing you need to keep your business running smoothly. It’s important to look beyond your credit score and consider the myriad other elements that may impact your approval for a loan.