For most small business owners, the need to build and maintain a good personal credit score never goes away. Although it’s true that some lenders tend to weight the value of your personal score higher than others (banks and other traditional lenders fall into this category) when they evaluate your business loan application, most lenders include a review of your personal credit score to determine your business’ creditworthiness.
This can be true for businesses with a few years under their belts as well as for those early-stage businesses looking for business loans for the first time. Nevertheless, in addition to a good personal credit score, small business owners also need to focus on building a strong business credit profile.
Your personal credit score is really a reflection of how you handle your personal credit obligations, and there are those who suggest it isn’t relevant to how your business handles its business credit obligations. Nevertheless, many lenders consider your personal credit score as one of the data points they consider when they review your business loan application, so it’s important to understand how your score is created, how it is considered when you apply for a loan, and what you can do to improve your score.
How is Your Personal Credit Score Calculated?
The early days of credit reporting were largely made up of local merchants working together to monitor the creditworthiness of their shared customers. With the passage of the Fair Credit Reporting Act in 1970, the Federal Government enacted standards to improve the quality of credit reporting.
In 1989, the FICO Score was introduced as the formula banks and other lenders started using to evaluate the creditworthiness of a potential consumer. Your FICO score is based upon data collected by the consumer credit bureaus. The three biggest are Experian, Transunion, and Equifax. All three of the major credit bureaus use the same basic scale from 300 to 850 to rank your credit, but the scores are rarely exactly the same.
That said, the fundamental formula used to calculate your FICO score is pretty straightforward and universally used:
- 35% Payment History: Late payments, bankruptcy, judgments, settlements, charge offs, repossessions, and liens will all reduce you score.
- 30% Amounts Owed: There are several specific metrics including debt to credit limit ratio, the number of accounts with balances, the amount owed across different types of accounts, and the amount paid down on installment loans.
- 15% Length of Credit History: The two metrics that matter most are the average age of the accounts on your report and the age of the oldest account. Because the score is trying to predict future creditworthiness based upon past performance, the longer (or older) the file is the better.
- 10% Type of Credit Used: Your credit score will benefit if you can demonstrate your ability to manage different types of credit—revolving, installment, and mortgage, for example.
- 10% New Credit: Every new “hard” enquiry on your credit has the potential to reduce your score. Shopping rates for a mortgage, an auto loan, or student loan will not typically hurt your score, but applying for credit cards or other revolving loans could reduce your score. According to Experian, these enquiries will likely be on your report for a coupe of years, but have no impact on your score after the first year.
How Does this Information Translate into a Credit Score?
The credit bureaus us the basic FICO formula to score the information they collect about you. They also capture your personal information like name, date of birth, address, employment, etc. They will also list a summary of any information reported to them by your creditors. You should be aware that other information available within the public record like judgments or bankruptcy will also be included on your credit reports and factored into your personal credit score. What’s more, any time you apply for additional credit will also be reflected on your credit report.
If there is something that is incorrect, the credit bureaus all offer a process to make corrections of verifiable errors. And, if there is something you feel requires additional information to describe an extenuating circumstance or otherwise provide context to something negative on your report, additions made to the Fair Credit Reporting Act in 1996 allow you to add a 100-word statement to any of the reports that include an item you dispute but wasn’t removed because it was verified by the creditor. Sometimes circumstances like a divorce, a prolonged illness, or job loss could explain a negative credit score. This gives you the opportunity to make sure potential creditors see that information.
There are some minor differences in the way the three major bureaus look at your personal credit information. For example, Experian includes data regarding whether or not you pay your rent on time. Equifax separates your open and closed accounts, and Transunion drives deeper into your employment data. The primary differences can be attributed to the fact that they are competitors and some creditors might report to one bureau and not the others. The differences in the data produce slightly different results, but the scores are usually very similar regardless of the bureau.
When a potential creditor looks at your score, here’s what they see:
300-579 (Very Poor): There is some financing available for borrowers with this type of credit score, but it’s considered a high-risk score and will likely come with fewer options and higher interest rates. It’s very unlikely this borrower would be able to qualify for a traditional bank loan or a loan from the SBA.
580-669 (Fair): This is considered a moderate-risk score. A small business loan is very possible, but will likely not come with the best interest rates. If your score falls within this range, you will have fewer options than those with a better score. Most traditional lenders won’t offer a small business loan to borrowers in this category and a 660 credit score is at the bottom threshold the SBA will typically consider.
670-739 (Good): This is considered a good score and many in the U.S. fall within this range. A borrower with this type of score can expect to see more options and more approvals.
740-799 (Very Good): If your credit score falls within this range you are considered a low-risk borrower and will be able to find a loan just about anywhere. A borrower with this credit score will be able to pick and choose the loan that makes the most sense for their business use case.
800-850 (Exceptional): With a score above 800, you can expect lenders will roll out the red carpet for you. Borrowers with this credit score will be able to choose the credit options that are optimal for their situations, often with the lender they choose.
For a more detailed breakdown on how your credit score is categorized, check out this guide from Experian.
What Can You Do to Improve Your Personal Credit Score?
There are no quick fixes to address problems with your personal credit score, but that doesn’t mean you can’t improve you score with some targeted effort. Here are six things you can start doing today that will positively impact your personal score:
- Know your score: Federal law requires you have free access to your credit report once per year. All three of the major credits reporting agencies offer credit-monitoring services for a fairly modest fee. What’s more, there are numerous free or modestly priced services available that also offer these services.
- Use credit wisely: This may sound like an oversimplification, but it’s important to avoid the temptation to regularly access all of your available credit. For example, even if you pay off the balance with every statement, maxing out your personal credit cards can negatively impact your score. If the goal is to improve your credit score, try to keep your credit usage to around 15 percent of your available credit limit.
- Don’t jump around: Transferring balances from one credit card to another doesn’t do anything to help improve your score. In fact, it’s considered a very transparent gimmick that might actually hurt your score.
- Make timely payments: Although this sounds like another oversimplification, it’s probably the best and most effective way to positively move your score in the right direction. 35 percent of your score is calculated by how timely you make payments and meet your obligations, so it’s something you can’t ignore. Even one late payment can lower your score.
- Don’t apply for credit you don’t need: Because credit inquiries reduce your score, applying for unneeded credit doesn’t make sense if you’re trying to improve your score.
- Slow and steady wins the race: There really is no shortcut to improving your credit score. However a focused effort over six months to a year can positively move the needle. Sometimes significantly. Alternatively, missing a payment or two will more than likely pull your score down significantly very quickly.
Your personal credit score might not be the best representation of how you will meet your business credit obligations, the need to build and maintain a strong personal credit score is very important for every small business owner. Most traditional lenders will heavily weight your score when they evaluate your business’ creditworthiness and most lenders consider the score in their decision-making processes—regardless of how long you’ve been in business.
*This article has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for health, tax, legal or accounting advice. You should consult your own health professionals or tax, legal and accounting advisors before implementing any business changes.