For virtually every small business owner in the U.S., the importance of a good personal credit score when seeking a business loan can’t be underestimated. While it might feel counter-intuitive to be talking about your personal credit score when addressing a business credit need, a low personal score has been responsible for the undoing of many small business loan applications.
Lenders look at your personal credit history as a measure of your past credit performance and your willingness to meet your financial obligations. If you have a less-than-perfect credit score, making efforts to improve your score often results in more options, better terms, higher approval rates, and lower interest rates.
Why understanding personal credit is important
For most small business owners on Main Street, your personal credit history is going to be a part of every business creditworthiness conversation you have with a lender. What’s more, one of the least appreciated or understood parts of owning and running a successful business is the importance of building and maintaining a credit profile that makes borrowing easier and provides options for financing that a poor profile doesn’t.
Here are a few other key areas impacted by your personal credit.
1. Securing business financing
Lenders will always look at your personal credit score to determine your creditworthiness even after establishing business credit. If you have a good personal credit score, it can increase your chances of securing a business loan or other forms of credit.
2. Interest rates and terms
Your personal credit score can also affect the terms of your business loan. A higher credit score typically leads to lower interest rates, which can save you substantial amounts of money over the life of your loan.
3. Vendor relationships
Some suppliers and vendors check personal credit scores before extending trade credit. Good personal credit can help you negotiate better payment terms.
4. Build business credit
Establishing a strong personal credit history can help you build your business credit. Over time, you want to develop a solid business credit history so that you can secure larger business loans without personal guarantees.
5. Insurance premiums
Insurance companies may check your credit score to determine your premiums. A better credit score might lead to lower insurance costs for your business.
6. Personal liability
If your business is a sole proprietorship or a partnership, you are personally responsible for business debts. Therefore, any negative impact on your business’s credit could affect your personal credit.
7. Business credit cards
Many business credit cards require a personal guarantee, and issuers will check your personal credit. A good personal credit score can help you qualify for cards with better rewards and lower interest rates.
How is personal credit determined
Most of the personal credit reporting agencies base their credit scores on the FICO score. Although their scores may vary slightly, the basic formula they use to calculate their scores is similar. FICO measures your score based upon these five data points:
1. Payment history (35%)
This is the single most important metric and where you can have the most lasting impact on your credit score. If you meet your credit obligations in a timely manner, in other words, if you make your mortgage payments, auto payments, and credit card payments on time every month, it is the most powerful way to build (or strengthen) your personal score.
2. Amount owed (30%)
The amount of credit you use when compared to the amount of credit you have available is what we’re talking about here. If you can keep your credit utilization (the industry term for this percentage) down below 30% it will positively impact your credit score.
The lower you can keep this percentage the better. For example, if you have $10,000 in credit available on your personal credit cards and you regularly run a balance between $8,000 and $10,000 (even if you make timely payments every month) it will reflect negatively on your FICO score. A $3,000 or less balance (30%) is preferred and if you can keep your credit utilization around $1,000 (10%), even better.
3. Length of credit history (15%)
Lenders like to see a track record. Basically, they are trying to determine what you will do in the future based upon what you’ve done in the past. In other words, the longer your credit history the better. So, that credit card you seldom use, but you’ve had for 10 or 15 years actually helps your personal score.
You may have a newer card that has better rewards points that you use more frequently, but it might make sense to occasionally buy a tank of gas or a dinner at a restaurant to keep it active and reflected on your credit report. In other words, from the perspective of building a strong personal credit score, avoid the temptation to cut up your credit cards and close accounts—even if you don’t use them very often.
4. Credit mix (10%)
Creditors like to see a mix of credit on your report; which is reflected in your score. A mortgage, an auto loan, and a credit card are reflected more positively than say, simply an auto loan.
5. New credit inquiries (10%)
Every time you apply for new credit there will be a slight impact on your personal credit score. In the normal course of life, this ding will be very slight, but you should be aware of it. The credit bureaus also treat shopping for an auto loan or a mortgage much differently than applying for every department store credit card available to you. Typically, it’s nothing to be too concerned about, but it is important to be aware of and shouldn’t prevent you from applying for the credit you need.
Now that you know how your personal credit score is calculated, you might be asking yourself, “What is a good credit score?”
What is a good personal credit score?
Although there might be differences from agency to agency, most rank personal credit scores like this (I’ve included the potential impact to a small business loan application):
800+ | Excellent
Long credit history with no late payments or accounts that were ever in collections. This rating will receive the lowest rates with the best lenders.
750 — 800 | Very Good
Likely to have a shorter credit history, but is still devoid of late payments or accounts that were ever in collections. This rating typically qualifies for low-interest rates with the best lenders.
700 — 750 | Good
There are no recent late payments or accounts in collections. Typically, you should be able to qualify for a good lender, but at a slightly higher rate.
650 — 700 | Fair
There are some recent late payments or accounts in collections, but everything is currently in good standing. This rating might exclude some bank loans, but you will typically qualify for a decent rate from most alternative lenders.
600 —650 | Bad
There are late-payments and the account owner is struggling with accounts in collections. Historically, the same is true. Some lenders may approve this rating for loans, but they will be at higher interest rates.
Below 600 | Very Bad
The account owner is in the middle of collections and has frequently had trouble in the past. You may be able to get a Merchant Cash Advance or Cash Flow Loan, but the rates will be high.
6 tips to improve your personal credit score
Whether you’re looking at a small business loan, an auto loan, or a new mortgage, lenders are trying to determine if you have the means to service debt and whether you are likely to make all your periodic payments. These five tips are not only credit best practices, I have personally seen the positive results in my own personal credit score.
1. Know your score
It’s human nature to positively influence the things you pay the most attention to, this is particularly true for your personal credit score. Regularly monitoring your personal score is the first step. I’ve personally had a relationship with Experian for many years and have watched my personal credit score improve—primarily because I’m paying attention to it every month (a monthly review is not too frequent). The first step is to know your score and although I’ve paid a small fee every month to Experian for the service, there are a number of services like Nav, that offer credit monitoring for free.
2. Use credit wisely
You might think this is an oversimplification, but it isn’t. Avoid the temptation to access all the credit you have available simply because you can. A good rule of thumb is to keep the ratio of credit you use compared to the credit you have available to below 30%. I am very conscious of every time I use a credit card, for example, and how it will impact my ratio—and I have been rewarded for it with a higher score.
3. Don’t jump around
Transferring balances from one credit card to another won’t help your score and is considered a very transparent gimmick that could actually hurt your personal credit score.
4. Don’t apply for credit you don’t need
Because credit inquiries can reduce your score, applying for unneeded credit could make improving your credit score more difficult.
5. Make timely payments
This probably goes without saying but this is the single most important thing you can do to improve your score. I’ve set up automatic payments to make sure I’m never late on things like my mortgage or auto payments.
6. There are no quick fixes or shortcuts to improving your score
This is one time when slow and steady really does win the race. You will be surprised at how these good credit practices can make a difference over six months or a year.
Do you know your personal credit score?
If you don’t, you should. What’s more, the three major personal credit bureaus: Experian, Equifax, and Transunion make it easy to access your score. And, for a modest fee, they’ll monitor your personal credit report and notify you every time something new is added or there’s a change.
Annualcreditreport.com is one place you can access your credit report for free once every year, but a simple internet search will reveal dozens of others—and many of them also offer low-cost credit monitoring. Just keep in mind that you can access free credit reports through Annualcreditreport.com but they do not include your credit score itself—you’ll have to pay for that.
Your personal credit score will likely always be an important metric for any lender evaluating you and your business for a small business loan. Guard it like the precious business asset it is.