Personal Credit for Small Business Owners: How Banks Think
Owning your own business is part of the American dream. Unfortunately it can make it more difficult to accomplish another part of the dream -- owning your own home -- or to get anything else that requires credit.
The definition of a “small business” varies by industry but can include companies with annual revenues as high as $7 million. Take a look at the Small Business Administration’s “Table of Small Business Size Standards” to get a better idea of where your business fits in.
If your company’s finances and your personal finances are essentially one and the same, you’re going to have the most trouble with credit. (If on the other hand you have a well-established $7 million small business and draw a regular salary as president and CEO, you’ll be treated like any other senior executive.)
Why does owning a small business complicate personal credit? Because banks loan money with the expectation of repayment. Anything that makes repayment look less likely or makes it more difficult to evaluate the prospect of repayment impairs your access to credit.
Here are some factors to remember when thinking about how you can make your finances look more attractive to banks:
- Salary history: About 75 percent of U.S. businesses do not have a payroll, according to recent information from the U.S. Census Bureau. Many owners forgo a salary for practical reasons, such as to avoid paying a FICA tax on their earnings. Instead, they take money out in other ways. However, banks look at your wage history as the first indication of your ability to repay a loan. Without W-2 earnings, you have no evidence of consistent salary or wages.
- Inconsistent earnings: Many business owners take out more money when the business is flush and less when times are tough or they’re reinvesting in the business. As explained above, this denies banks or lenders a consistent earnings history on which to base expectations of repayment.
- Tax losses and earnings: Many small businesses use a “pass through” tax structure that allows the owner to take advantage of tax losses. Unfortunately, lending guidelines commonly state that it is the income reported on the federal tax return that is used to determine creditworthiness. The tax loss saves you money but lowers your federal taxable income and reduces your likelihood of getting a loan.
- Contingent liabilities and debt exposure: Small business owners often personally guarantee business debt or put it on their own personal credit card. Doing this has a negative impact on your overall debt-to-assets and debt-to-income ratios, since all your debt, including contingent liabilities, is counted when evaluating creditworthiness.
- Financial game playing: A small business owner can direct how much money their company pays out and when it does so. Banks fear that the owner will cause the business to make extra salary payments in advance of a loan to artificially and unsustainably improve the appearance of the owner’s finances. This makes lenders cautious.
- Inherent riskiness of newer or smaller businesses: According the SBA, 50 percent of small businesses fail within five years. Therefore small companies have fewer reserves to withstand reversals. Banks view their—and therefore the business owner’s—finances as riskier.
Steven Zweig, a former SEC attorney and corporate counsel, is owner of Comprehension Publishing. He has an inside perspective on the challenges that small business owners face today.
