Do business loans use personal credit? Usually, yes.
Unlike the CEOs of major public companies, whose personal financial situation has little effect on their companies’ borrowing, if you are a small business owner, your personal credit is a major factor influencing your company’s access to capital. There are several reasons that small business owners’ personal credit affects business loans. Their companies’ access to capital is related to:
- The power of personal credit scores to predict small business loan repayment.
- The legal structure of many small businesses.
- Small business owners’ use of personal guarantees and personal borrowing to finance business operations.
Many lenders will look at your personal credit score if you are a small business owner seeking a business loan. A report written for the U.S. Small Business Administration found that 71 percent of banks used small business owner credit scores when underwriting small business loans.
The use of the owners’ personal credit scores makes sense. As Federal Reserve Bank of Atlanta researchers explain, the personal credit record of the business owners is a good predictor of the repayment of business loans of less than $100,000.
The legal structure of small businesses also links personal credit to business access to capital. Approximately 72 percent of U.S. businesses are sole proprietorships, Internal Revenue Service data indicate. The debts of sole proprietorships are not legally distinct from those of their owners. Therefore, lenders and trade creditors pay careful attention to the personal creditworthiness of sole proprietors.
Even when small business owners set up corporations to limit their personal liability for the debt of their businesses, they often tie their personal credit to their companies’ borrowing. They do this by personally guaranteeing the debts of their businesses and personally borrowing to finance their companies’ operations. According to analysis by the Federal Reserve, 41 percent of all small business loans and 56 percent of small business borrowing are personally guaranteed.
Studies show that many small business owners borrow personally to finance their business operations, further intertwining small business loans and owner personal credit. A paper by Alicia Robb of the University of California at Santa Cruz and David Robinson of Duke University indicates that about one quarter of new companies are funded by the personal borrowing of their founders.
For many small business owners, tapping home equity is an important way personal credit is transformed into business capital. Analysis by Minneapolis-based market research firm, Barlow Research shows that about one quarter of small business owners tap the equity in their homes to finance their businesses. Owners do this either by using their homes as collateral for business loans or by taking home equity loans and plowing the proceeds into their companies.
Drawing on personal credit card credit lines is another way that small business owners use personal credit to finance business operations. According to Intuit’s Future of Small Business Credit Report, small business owners have $150 billion in outstanding credit card debt that they have used to finance their businesses.
As you can see, very often small business loans are based on personal credit. In addition, personal credit will affect the ability to get a business loan.
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I don’t like the idea of using home equity to fund a business, but I understand why banks would look at the credit history of the owner for loans. Past behavior is a good predictor of future behavior and banks are still really gun-shy with their loans.
I agree with Robert’s comment. From the bank’s point of view, they would need a guarantee from the people they lend money to. Also, I am certain the bank’s not a big fan of the quote “I am a changed man”, so better keep your record clean cause it sure will come in handy in the future.
It is not that surprising because most small businesses are dependent on its owner. If the owner does not have a good credit score, then there is a good chance that he is not capable of sustaining his business – which makes him or her not capable for taking some loans.
Also, as a business matures, it’s business credit scores/profiles become increasingly important for things like better terms on commercial trade lines, credit cards, etc. A lot of people are unaware that their business has a credit score too.
Helpful article. Thanks.
I’m surprised it’s as low as 25% of new small businesses are funded personally by the founders, would’ve expected it to be much higher.