Applying for a small business loan is a critical step in the life cycle of most entrepreneurs, so doing it correctly is important. Fortunately, the steps you’ll need to take are fairly straightforward.
From monitoring your credit profile to choosing a lender and more, here are five key categories you need to consider before beginning the process.
While large organizations apply for loans based solely on the business’ credit, most lenders need to review your personal credit profile when you’re seeking a small business loan. Lenders know that your business is intimately tied to your own life, and they want to confirm that you’ve demonstrated the ability to manage your personal finances successfully.
Each lender has its own methods for calculating and evaluating credit scores, but in most cases, you’ll need a FICO score of at least 700 to be considered a “good” credit risk.
Take these steps to ensure your score is as high as possible:
- Regularly request your credit profile (and verified FICO scores) and review the data carefully for any errors, including misspellings, unknown accounts or accounts that report incorrect information.
- Always ensure you make on-time payments for any account reported on your credit profile.
- Be sure your account balances are always reporting as low as they can be — you can do this by timing your payments so that they’re posted just before the “statement closing date” from each account provider every month.
- Keep old accounts open even when they’re not in use, since the average age of all accounts is an important scoring factor.
Even when you’re just starting out, it’s always better to start building your business credit history as soon as possible. Doing so improves your chances for approval when applying for a small business loan, and can eventually allow you to start managing your business based solely on the business credit profile, without involving your personal credit at all.
The factors influencing your business credit score are similar to your personal score, so on-time payments and responsible credit usage should be a top priority with business accounts.
Business credit scores are calculated by three separate bureaus, each of which maintains its own scoring algorithms and scales. The three bureaus are Experian, Dun and Bradstreet (D&B) and FICO, and you should request your business profile from each one to review and identify areas that need improvement.
Debt Service Coverage Ratio
While your credit profiles are the first step into the door when applying for a loan, your debt service coverage ratio (DSCR, sometimes DCR) is the single most important factor that will determine whether you’re approved for a specific loan amount.
The DSCR is a ratio that compares your income in relation to the cost of servicing any debt you already have. For a small business loan, a good DSCR is 1.25 or more — being approved with a lower ratio is unlikely, and will certainly lead to a much higher APR even if you are approved.
Your DSCR is calculated according to a simple formula: Annual net operating income / annual debt servicing costs.
In most cases, you’ll use your EBIT (earnings before interest and taxes) to calculate the ratio, but in some situations, it’s better to use the EBITDA (earnings before interest, taxes, depreciation and amortization) instead.
Learn more about how to calculate your DSCR here.
Choosing a Loan Provider
Once you’ve ensured that both your personal and business finances are in good order, it’s time to determine which loan provider you’ll pursue an application with.
In many — but not all — cases, you’ll find the best interest rates with a Small Business Administration (SBA) loan. Remember that SBA loans are guaranteed by the government, not provided by it. That means you’ll still be working with a private lender but under the framework of the SBA loan program.
SBA loans are often less expensive than other loans but have a correspondingly more complicated application procedure. In particular, SBA lenders are very stringent about your ability to repay, so your business will need to demonstrate solid financials before even considering an application. Learn more about preparing for an SBA loan application here.
If you can’t get approved for an SBA loan, your next step should be to seek a private business loan with a bank. Banks offer much lower interest rates than alternative lending products but are just as stringent about their qualifying requirements as the SBA. Because small business lending is notoriously risky, you’ll still have to ensure that all of your paperwork and credit information is in pristine condition. Learn whether you qualify for a business loan from a bank here.
Comparing Loan Options
Beyond choosing a lender, you need to compare the actual loan products that are available to you. The best way to go about this is to use the same criteria a bank will use when evaluating you as a lender: affordability.
Affordability is calculated using your DSCR or debt-to-revenue (DTR) ratio, and simply describes whether you can afford the loan. From a business owner’s standpoint, that means evaluating the loan’s APR interest rate and other servicing costs.
Calculating your APR for a loan can be complicated, so you may need to work with a lending officer to ensure you understand the complete terms of your loan. Once you’ve done so, add the interest costs to other debt servicing costs like fees or penalties, and use that total figure to decide whether you can afford the loan.
As long as you carefully review your credit histories and financial information, then work with your loan provider to ensure you get the best deal possible, you can use business loans as an important tool to fuel the growth of your business.