A behind-the-scenes look at small business lending
Applying for a business loan can be a daunting task, especially when you consider the fact that banks reject more than half the business loan applications they receive. When you’re facing a task like this, sometimes it helps to look at things from a different angle.
That’s why we sat down with Oscar Novelo, the founder of Eleva Financial, and asked him to share some advice based on his long experience as a small business banker and loan officer.
Things to consider about small business lending
The rules are different: When a lender offers loans to individual consumers, they’re subject to regulations and consumer protections that often don’t apply to commercial (business) loans. For example, the Truth in Lending Act requires lenders to provide specific, consistent information about the costs of their consumer loans. This regulation generally does not apply for business loans.
The lines are blurred: As a business owner, you may have taken steps to separate yourself from the business and protect yourself from liability. When you start looking for a loan, however, you’ll find that business lenders will probably check your personal credit and they may require you to offer a personal guarantee (which means you promise to use your personal assets to repay the loan if the business cannot).
Different lenders have different motives and models: When you start looking for a loan, you’ll notice that there are many different lenders out there with wildly different interest rates, fees, and terms. Each of these lenders typically have different eligibility requirements. In general, the more favorable the terms, the stricter the application requirements. Oscar has some inside perspective on why that’s the case.
_First-tier lenders, the ones with the lowest interest rates, are not in the business of coming after someone and taking away collateral. They want you to repay the loan. That’s why it tends to be a little more difficult to qualify for these loans.
Other lenders, like hard money lenders, are particularly interested in the collateral. They may actually issue loans banking on the possibility that the borrower will default—allowing the lender to take the collateral asset. It sounds cutthroat, but that’s their business model._
How lenders evaluate loan applications
Different lenders look at different criteria when reviewing credit applications, but as a general rule, they’re likely to look at most of the following.
The business’s financial history: Oscar says that in his experience, lenders place a lot of importance on your business’s historical performance, especially its profits. If you can show increasing profits year-over-year, that’s a strong indicator that you’ll be able to repay the loan.
Your personal credit: Even though it’s a business loan, lenders are almost certainly going to look at your personal credit. Oscar says, “A lot of banks really look at a credit score of 680 as the cut-off for good credit. This can vary from lender to lender, but typically it’s safe to say that 680 is a good spot to be. If your score is lower than 680, then some lenders will still look at you but they start dropping off as your score decreases. If your score is below 660, it becomes difficult and below 640, it’s very difficult.”
Your business credit: If you’ve been in business for a while and you’ve established good business credit (more on how to do this below), this will strengthen your application and potentially increase the amount you’re able to borrow.
Any collateral: Many loans are secured by collateral (a valuable asset that the lender has the right to seize if the loan is not repaid). Mortgages, car loans, and equipment loans are all examples of loans that are secured by collateral. Lenders are generally more likely to approve secured loans because they limit the lender’s financial risk.
What you can start doing now if you want credit in the future
Even if you’re not looking for a loan anytime soon, there are a few steps you can take right now that might increase your access to credit in the future.
Start building your business credit: To do this, Oscar says, you need to consider three specific things. You might notice that the process is pretty similar to building personal credit.
- First, you’ll need to get a DUNS number from Dun and Bradstreet. You can do this pretty quickly and easily from their website. Lenders can use the DUNS number roughly the same way they’d use an SSN for an individual—it’s a unique identifier that can be used to gather, report, and share information about your business’s creditworthiness.
- Start getting credit history reported to Dun and Bradstreet. If you have vendors, see if they can report to Dun and Bradstreet. If you don’t have one yet, consider getting a small business loan or a business credit card—and when you do, give the lender your DUNs number and ask them to report your business credit history.
- Regularly check your Dun and Bradstreet business report to confirm that everything is being reported correctly.
Don’t neglect your personal credit: As Oscar mentioned, most lenders will look at your personal credit as well as your business credit and finances. That means improving your personal credit now will allow you to get larger loans or lower rates for your business in the future.
You can find tons of in-depth resources on building your personal credit, so here we’ll stick to the basics.
- If you don’t have any open loans or credit cards, consider getting a secured credit card or credit-builder loan and make sure the lender will report your activity to the credit bureau in order to build your credit file.
- Make your payments on time.
- Don’t close credit card accounts unnecessarily.
A lot of guides to building credit will also advise you to keep your credit utilization low and avoid applying for a lot of loans or credit at once. These tips are good ones, but they have relatively short-term effects. If you’re not planning to apply for a loan for a couple of years, you probably don’t need to worry about them yet. If you’re planning to apply for a loan in six months, they’re much more significant.
Show a path to profitability: When you’re looking for a loan, you want your financial records to show increased revenue and profits year over year. Now, this might seem like an obnoxiously obvious point (who doesn’t want more profit?) but it’s worth mentioning here since keeping this goal in mind may affect how you plan for expenses.
For example, Oscar remembers working with a client who was initially denied a loan because her latest tax return showed a loss. When he asked her to tell him about the loss, she explained that she’d made a very large purchase in December. If she had waited until January to make the purchase, her tax return for that year would have shown a profit instead.
All this goes to say that when you’re planning to make a large purchase, you’ll want to think about how it’ll affect your year-over-year financial records as well as your cash flow and your tax liability.
How to present a strong application now
Preparing in advance is all well and good, but what if you need capital right now?
Oscar says the best thing you can do is be informed, have realistic expectations, and have a good story. You’ll also need to find a lender who is willing to listen to your story and work with you. Some lenders have a more automated, rigid approval process, but others may be able to make adjustments (exceptions in banking lingo) if there’s a good reason to do so.
For example, let’s say you aren’t able to show strong profits year-over-year. There are a couple of ways to approach this depending on your situation.
- If your profits are low because your business is new and you’ve only recently crossed the break-even point, show the lender your path to profitability. If your business’s financial history shows that your revenue is increasing and your losses are decreasing, that’s a promising sign to lenders.
- If your profits suffered due to large, one-time expenses, talk to your lender or a loan advisor and see if you can add them back to your profit line. Remember the client who showed a loss on her tax return because she made a large purchase in December? When she explained the situation to Oscar and provided an invoice, he was able to add that expense back and show the lender that she could have made a profit that year. Oscar says it may be possible to talk with your lender about adding back other expenses, such as one-time expenses, interest paid, depreciation, amortization, and business rent (if you’re buying a building for your business).
Another thing you can try to do is get lenders to look at your future potential. In general, lenders look at past performance rather than future earnings. If you have income that’s practically guaranteed to come in soon, however (such as a large contract or outstanding invoices) you can ask the lender to consider that in their calculations.
Oscar remembers working with one client who did an especially good job of telling the right story—when he was applying to increase his line of credit, he explained exactly why he needed the capital (he just got a large contract and needed funds to pay workers and purchase materials), why he didn’t have the cash on hand (he’d invested in a lot of equipment recently) and how he’d be able to repay the loan (with the proceeds from the contract). By being informed and proactively speaking to the lender’s potential concerns, he was able to make a strong case and ultimately get the loan.
How to evaluate different lenders
Now that we covered how lenders look at potential borrowers, let’s turn the tables. If you’re an entrepreneur looking for a loan, how do you decide whether or not a potential lender is a good fit for your needs? Oscar also has some tips on assessing lenders and loan options.
Ask about pricing
When you’re comparing loan options, the first thing most people look at is the interest rate. The tricky thing is that most lenders offer a wide range of different rates depending on the borrower and the loan terms. Generally, lenders won’t give you an idea of the rate they’ll be charging on your loan until you apply—but who wants to go through the hassle of a loan application before they know whether or not they actually want to accept the offer?
Here’s Oscar’s advice on how to get a better idea of pricing before you actually apply for the loan.
If you ask “What’s your rate” and they aren’t able to answer, try asking “How do you price? Do you use Wall Street Prime or another index?” Then you can ask them what kind of spread they typically have on that index. Once you have that information, you can approximate that rate. For example, if the Wall Street Prime rate is 5% and their margin is 3-5%, then their interest is roughly 8-10%.
Here’s a quick definition of some of the lender-specific terms and concepts in that quote:
- Many lenders price their loans by taking a fixed base rate (also called an index) and then adding a variable margin (also called a spread). The total rate is determined by adding the base rate and the margin.
The Wall Street Prime rate is a commonly used base rate. It’s defined by the Wall Street Journal as the “base rate on corporate loans posted by at least 70% of the 10 largest U.S. banks.” This means it’s very commonly used as a base rate for business loans.
Look at the fees and fine print
Many loans come with fees that can add a lot to the total loan cost. When it comes to consumer loans, lenders are required to disclose fees and costs in a clear and consistent manner, but that’s not always true for business loans. That means it pays to do your homework. Common fees include origination fees, early repayment fees, late fees, underwriting fees, and closing costs.
Oscar says it’s also a good idea to ask lenders what type of covenants they commonly put on loans.
A lot of times, a lender will end their loan documents with covenants—stipulations or promises that you, as a borrower, will have to honor. Some of them might limit or prevent you from taking out owner draws, repaying shareholder loans, or stop you from borrowing from another lender.
Get to know them
When you’re shopping for a loan, you’ll probably find yourself talking to a few different lenders. As you do, you’ll get a feel for how transparent, knowledgeable, and helpful they are. When you ask questions, do they answer them promptly and thoroughly, or are they vague and unresponsive? When you take out a loan from a company, you’re signing up to work with them for a substantial period of time so it’s a good idea to make sure you’re going to enjoy being their customer.
The more you know
Hopefully, this glimpse into the lending industry has given you a better understanding of what to do and expect (and more importantly, why) when you start looking for a business loan.
Although getting a business loan can be challenging, you can increase your odds of success by being prepared and informed, understanding the lender’s business model and motives, and finding the right people to work with.
This content is for informational purposes only and does not constitute tax, accounting, legal, or other professional advice. Please do not rely on this content for any specific purpose without obtaining personalized professional advice. Also, Azlo doesn’t endorse any third-party sites that are linked in this post.
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