Are you in the midst of starting or growing a business? Maybe you aspire someday to be your own boss. Often, entrepreneurs don’t understand how their personal credit history impacts their business.
As you set goals and make plans, keep in mind that your personal financial actions today could help or hinder your company’s ability tomorrow to access business funding, commercial space, insurance, and other opportunities.
Your demonstrated experience and history of paying your personal bills and debts on time and as agreed is referred to as “personal credit.” Your personal credit is an asset, and is measured by different scoring models, such as FICO and Vantage. (More about that later!)
If you’re a startup, you likely have little to no business credit history, so banks, landlords, and others making commercial credit decisions will be heavily reliant on your personal credit history and personal credit score. Your personal score will feed into your business score, but it doesn’t work the other way around.
How Many Types of Credit Are There?
Credit refers to the ability to access funds from lenders. There are three different categories of credit. Each can impact your personal and/or business credit scores, so it is important to understand them as you seek to improve or sustain your financial health:
1. Revolving Credit. Revolving debt, such as credit cards and home equity lines of credit, allow you to borrow funds at any time up to a set limit. Your balance becomes available again once the charges or draws are paid back. There is a minimum monthly payment required, and interest will accrue if paying off the total amount owed takes more than one month.
2. Installment Credit. Installment debt, such as mortgages or business loans, allows you to borrow a specific amount of money for a particular purpose over a specified period of time called a “term." With installment credit you will have a fixed payment due each month that is paid over a set period with a set amount of interest. Once the debt is paid in full, the loan amount is not available again.
3. Open Credit. This describes financial balances that must be paid in full each month, such as cell phone, utilities, cable and internet accounts. You cannot push debt out to the next month, so there is no interest charged.
What is a Credit Score?
Each of us has one, but how much do you know about what goes into a credit score? Typically a credit score consists of a variety of criteria including payment history, amounts owed and length of credit history. In addition, there are several types of credit scores, including:
FICO Score
The FICO score has only been around since 1989, and yet 90 percent of top lenders rely on this scoring model. FICO credit scores range from 300 to 850 based on the following criteria, in order of importance:
- Payment history
- Amounts owed
- Length of credit history
- New credit
- Types of credit
VantageScore
The VantageScore is an alternative credit scoring model that was created by Experian, TransUnion and Equifax in 2006. VantageScore credit scores range from 300 to 850 based on the following criteria, in order of importance:
- Payment history
- Credit age and mix
- Utilization or amounts owed
- Balances
- Recent credit applications
- Available credit
FICO SBSS Credit Score
SBSS stands for Small Business Scoring Service and is used for business term loans and lines of credit up to $1 million. SBSS credit scores range from 0 to 300 and are based on personal credit of the principals/guarantors of the business, the business credit histories, the age of the business and other application and financial data. The algorithm is not publicly available, and a borrowing company cannot purchase this score as you might purchase your personal credit score.
When working with a lender, be sure to do your homework to understand which credit score they will use to evaluate your credit worthiness. Equifax, Experian, and TransUnion offer free weekly online credit reports so you can regularly check your credit history for accuracy.
What is the Cost of Bad Credit?
Having poor credit can cost you — literally — since interest rates on loans, lines of credit, credit cards and other products are influenced by your credit score. For example, depending on the amount of the financing request, the difference in interest paid over the life of the loan can amount to thousands of additional dollars for an individual with a low credit score. This can be true for a company that has a low business credit score.
For example, according to the FICO Loan Savings Calculator, on a 30-year, fixed-rate $300,000 loan, a borrower with a low FICO score (620-639) could expect to pay $93,657 more in interest over the life of the loan, compared to a borrower with a high FICO score (760-850). This amount can fluctuate based on the annual interest rate.
What Are Common Credit Mistakes?
A common mistake is a person paying cash for everything and foregoing credit products altogether. An individual with no personal credit history is viewed as high risk by a bank or other creditor because there is no history at all to predict what that person will do if they are extended credit.
Another common credit mistake is closing a long-standing credit card. The recommendation is for credit cardholders to keep established accounts open since the length of credit history is vital to your score.
A credit card may also be closed by the creditor due to inactivity, so it’s important to use your cards at least occasionally and pay off any balances promptly.
Another common credit mistake involves using too much credit. A good rule of thumb is to keep credit utilization no higher than 30% of your limit. You want to aim for a balance between no activity and too much utilization. Maxing out your credit cards isn’t wise, but a common misconception is that zero utilization across the board helps your credit, which is untrue. That’s because when you don’t use your credit card, the creditor has no information — positive or negative — to report to the credit bureaus.
What are the 5 C’s of Credit?
Banks and other financial institutions make lending decisions based on “The Five C’s of Credit.” The Five C’s stand for:
- Character: Assess the borrower’s trustworthiness and reliability. Credit scores are one of the ways the lender evaluates character.
- Capacity: Evaluates the borrower’s ability to repay the loan by reviewing income, expenses, and debt-to-income ratio (consumer loan) and business debt service coverage (commercial loan).
- Collateral: Concerns tangible assets the borrower offers to secure the loan in case of default.
- Capital: Examines the borrower’s financial assets or net worth as a buffer for repayment. It also refers to what down payment, referred to as “owner’s equity injection” in business lending, is provided.
- Conditions: Looks at external factors like the loan’s purpose, economic and financial environment, and industry trends.
The Five C’s are critical when it comes to loan decisions.
Are you an entrepreneur in need of resources and support?
Let the Zions Bank Business Resource Center assist you in getting your business off the ground with financial resources and tools for aspiring, new and existing business owners, from consultations to virtual classes. Services are complimentary and available to the public regardless of where you bank.
