With an estimated 99.95 percent of small business owners and entrepreneurs opting for debt financing, knowing how to prepare your business for a loan application is a must.
Among the documents that a lender will review, your personal credit as well as your business credit are criteria that play an important role -- both can either assist, or in some cases obstruct, your ability to secure financing.
Let’s review some key strategies that everyone needs to know about personal credit score vs business credit score.
Personal credit score vs. business credit score: what’s the difference?
These two scores are often independent of each other and they measure different things. Your personal credit score measures your creditworthiness -- your personal ability to pay back a debt. On the other hand, a business credit score measures the ability of your business to meet its own financial obligations. Let’s take a look at each one in a bit more detail.
What it is:
Your personal credit score helps a lender evaluate whether or not to offer you credit, how much to lend you and what terms (e.g. APR, requirement of collateral) to use. While different personal credit scores have different ranges, one thing never changes: the higher the score, the more financially trustworthy a borrower is considered to be.
Who and what determines your personal credit score:
Using your Social Security Number (SSN) and your credit history, the three credit reporting bureaus (Equifax, Experian and Transunion) assign your creditworthiness a score, all using variations of the FICO Score algorithm.
Ranging from 300 to 850, the FICO personal credit score is made of five key components:
- Payment history (35 percent): The most important factor in a FICO score is your payment history to lenders. Your ability to pay on time is the first thing that lenders take a look at.
- Amounts owed (30 percent): The whole point of seeking a high credit score is to be able to borrow money when you need to. Owing money doesn’t necessarily make you a high-risk borrower but maxing out your credit cards and carrying a high balance on them for several months will negatively affect your FICO score.
- Length of credit history (15 percent): It takes time to build a good credit score. In general, the longer a credit history, the higher a FICO credit score.
- Credit mix (10 percent): There are different types of debt, including retail cards, credit cards, car loans and more. Without some form of debt, FICO can’t determine your score. So, you need to responsible use credit cards and installment loans to start (and build up!) your score.
- New credit (10%): FICO believes that opening several new credit accounts within a short period of time increases your credit risk.
Tips to boost your personal credit score:
- Automate your credit payments. Since paying your lenders on time represents 35 percent of your FICO score, sign up for automatic payments for all of your credit accounts. Most lenders allow you to set up auto payment using your bank’s routing number and account numbers. Another option is to schedule payments using the bill payment service from your bank or a third-party payment processor, such as Mint.com or MyCheckFree.com.
- Adjust your due dates. You don’t have to settle for a due date that is poorly timed with your paycheck. Except for those of mortgages, most due dates can be adjusted with a quick phone call. Depending on your lender, the change may take two to three bill periods to take effect.
- Aim for a credit utilization ratio of 30 percent. Whenever you can, pay off your credit cards in full month after month. If that’s not possible, then aim to have a balance of no more than 30 percent than your credit limit for each card. A credit utilization ratio of under 30 percent across all cards is a sign for lenders that you’re managing your credit responsibly.
- Handle new credit carefully. Chasing too many of those deep discounts for opening store cards will eventually catch up with you. Every time that you open a new account, your FICO score takes a small hit. So, open a new card only when you really need to.
- Don’t close oldest accounts. The number of years that you have held each one of your cards and debts affects your length of credit history. By closing your oldest account, you may dramatically reduce your length of credit history and negatively affect personal credit score.
- Order your free credit report every 12 months. FICO and all lenders use your credit history to determine your creditworthiness, so making sure that your credit report is accurate is a must. Every 12 months, request your credit report. Verify that all you personal data, including SSN and mailing address, and listed accounts are correct. To dispute any inconsistencies, follow the instructions on your credit report or file a dispute online with Equifax, Experian or TransUnion.
What it is:
Also known as a trade or commercial credit score, your business credit score helps financial institutions to determine whether or not you’re a good candidate for debt financing. A high business credit score can improve your chances of obtaining a business loan -- and likely, you’ll be able to receive much more favorable terms. Alternatively, a low score can mean higher interest rates, and in some cases, even prevent you from being eligible to borrow.
Additionally, vendors and suppliers often check your business credit score when considering whether to invoice your business on a Net 30 or Net 60 basis.
Who and what determines your business credit score:
Just like a SSN for individuals, an Employer Identification Number (EIN) allows the IRS and the credit reporting bureaus to track businesses. If your small business is incorporated and has an EIN, registering it with Equifax, Experian or Dun & Bradstreet is the first step to establish your business credit score.
- Equifax: Using your business’ payment history, ratio of available credit to utilized credit, age and size, demographics and public records, Equifax scores your small business credit in a range from 101 to 992 on the Small Business Credit Risk Score for Financial Services and in a range from 101 to 816 on the Small Business Credit Risk Score for Suppliers. Equifax takes the small business owner’s personal credit score into consideration as well.
- Experian: Ranging from 1 to 100, Experian’s business credit score takes into consideration similar factors as Equifax. Experian gathers data from lenders and vendors that have extended a credit line or loaned money to your business and compares all of that data to peers in your industry.
- Dun & Bradstreet: Focusing on the one-year payment history of your business, a financial stress score and other data from at least four vendors, Dunn & Bradstreet’s PAYDEX report uses a 100-point scale to rank your business credit.
Tips to boost your business score:
- Establish credit lines with vendors and supplies. It takes data to create business credit scores and Dun & Bradstreet requires at least four vendors to generate its report. Take the time to build up relationships with vendors and suppliers so that they’re willing to sell you on credit on 30- or 60-day basis. No matter how small a vendor is, he or she may become a future trade reference for your business at the time of a loan or business credit score request.
- Make timely payments. Return the favor by paying to those vendors and suppliers on time at all times. This will not only help you create a solid payment history but also make those businesses and individuals more likely to report your payment history to the credit reporting bureaus.
- Aim to cover all your annual debt obligations with net income. Just because your business can borrow up to $100,000 from a credit line, does not mean you should borrow the full $100,000. A useful rule of thumb is that your net income (revenue after subtracting all costs of doing business) should be at least equal to your annual debt obligations. Showing that your business’ cash inflows is sufficient to meet its obligations has a positive impact on your business credit score.
- Request your business credit report today. Having a have a couple of months -- instead of a couple weeks -- makes improving your business credit a more feasible project. Building business credit takes time, so it’s useful to get a picture of what is your current score and what are areas for improvement. Some credit bureaus, such as Experian, provide you reason codes that help explain your score and provide advice on how to improve it.
- Track your business credit every quarter. That’s how little it can take for your score to change and can give you a heads up on a damaging report from a vendor or on the effects of an increase in your utilized credit. Take the lessons from every credit score report to learn how to become the type of borrower that a lender caters to in the future.
- Check your report for inaccuracies. If you find an error in your report, report it right away to the relevant bureau using supporting documentation. Pay particular attention to errors in information under public records. Bankruptcies, judgments from debt collection lawsuit, and creditor’s legal rights to seize your property in the past seven years on your report could lead to an automatic denial of your loan application.
Do I really need a business credit score?
Yes, because a business credit score helps you in separating your business from your personal finances. During the application process, your underwriter will take a look at additional documentation, such as bank statements or business credit reports. Keeping your finances separate is important for two key reasons.
- Tax purposes: While you can claim an extensive list of small business tax deductions, you need to provide appropriate supporting documentation. In case of an audit, you need to be able to clearly demonstrate that every single deduction was an actual expense directly related to your business operation. If you’re unable to clearly demonstrate that, you may be subject to penalties, including negligence, late payment and fraud.
- Liability for debts: If your business is structured as a corporation or limited liability company, documenting that your finances are separate prevents a creditor from having a stake on your personal assets to satisfy a debt.
How to do it:
- Establish a separate legal entity for your business. Choose a business legal structure that works best for your unique situation. If you’re considering to form a corporation, consult with a lawyer and accountant to have a good understanding of applicable rules, including those for tax reporting, compliance and operation.
- Apply for an EIN online for free. You will need this to stay on top of your small business finances, report to the IRS and establish your business credit score.
- Establish a business credit score. Because it’s supporting evidence that demonstrates your business’ payment history. It doesn’t hurt that it will also help you secure the necessary debt financing to fuel the growth of your business.
- Open a business checking account and credit card. Using your EIN, establish separate bank accounts and credit cards for your business. The statements from these accounts are appropriate supporting documentation to keep track of business expenses.
- Hire a professional bookkeeper or accountant. Commingling your finances can backfire at the time of tax filing or loan application. It’s possible that you misunderstand what would be considered personal debt. Could be you have business debts you’ve forgotten to include in your financial statements. Hiring the services of a professional bookkeeper or accountant enables you to focus on the core operations of your business. It also helps you better meet compliance requirements. When evaluating bookkeepers and accountants, pay close attention to their schedule of fees and range of services.