With the economy slowing in response to COVID-19, millions of business owners have seen their incomes drop and are increasingly relying on financing to help fund their businesses. In most cases, the financing options available are based on the business owner's personal credit score, so it's important to know what may work for you before deciding which to use.
How credit scores affect loan options
Before diving into the types of loans that work for good, average, and poor credit, let's discuss how a business owner's credit score affects their financing options.
While businesses can establish their business credit scores separately from the personal scores of their owners, this process takes years and lots of revenue. For the vast majority of small businesses, lenders assessing the loan application will look to the owners as the principal source of repayment. This means that the lender will want to consider the business owners' personal incomes, assets, and liabilities as well as credit.
Lenders consider the credit scores of potential borrowers as an indication of the risk they pose – i.e., how responsible they are with credit. This, in turn, indicates how likely the borrower is to repay the loan, and whether the lender should consider them creditworthy.
Depending on credit score, some business owners only qualify for certain types of financing. If a business owner's credit is too low (below 550 to 600), they may not be able to get a loan at all.
Business financing and changing credit
Even after you've secured a small business loan, your credit score is still important. Some loans include provisions that allow lenders to call the loan if your credit score or the value of collateral drops too much, though these loans are fairly rare.
More often, refinancing becomes far more difficult if your credit score drops after you secure financing, which may leave you stuck paying interest on a high-interest loan – or, if you have balloon financing, you could end up unable to refinance your balloon payment and have to pay it all at once.
If your credit score improves, you may qualify for a better loan or have the option to refinance your debt at a lower rate or for a longer term, drastically lowering your monthly payments.
Types of small business financing for each credit score
|Type of financing||Type of credit|
|Bank term loan||Excellent|
|Business line of credit||Fair|
|Merchant cash advance||Poor|
While you assess each of these options, it's worth remembering that a borrower's credit score isn't the only determining factor in whether a certain type of financing is right for them or even if they'll qualify. For each of these loans, there are other types of requirements as well, including time in business, revenue and debt-to-income (debt-service coverage) ratio.
In some cases, other nuanced requirements may also exist. Merchant cash advances, for instance, are only available for businesses that process credit card transactions, and SBA loans are only available for businesses that have been denied financing from other sources.
Bank term loans
When it comes to small business financing, bank term loans are the gold standard – as good as it gets. This type of financing is typically reserved for the most creditworthy borrowers – business owners with strong, reliable business revenue, excellent credit, and usually an established relationship with a bank.
With a term loan, a bank extends a direct loan to a business – the loan is not federally insured – and the business repays the loan through regular payments over a period ranging from five to 30 years.
While bank loans are ideal for small business financing, they're extremely hard to qualify for, and because these loans aren't federally insured, the interest rates aren't always great for non-prime borrowers (if they even qualify). If you don't have an established relationship with a bank, they often aren't even an option.
Bank term loans are best for small business owners who want to do one of these things (or the like) with the funding:
- Buy or expand their business facilities
- Purchase new equipment, supplies or inventory
- Buy another business or open a new location
For business owners who have good credit and want a term loan but don't have the stellar credit or established relationships necessary to get a bank loan, the SBA is often a great choice. Borrowers still need to have good credit to qualify, though (600 to 640 is the minimum for most programs).
When it comes to SBA loans, there are many different options available. Most loans issued by the SBA are conventional term loans, but there are also lines of credit, microloans, grants and other options to fit a business owner's particular circumstances. These options are usually offered at more attractive rates than business owners would get from other non-bank lenders.
One of the great advantages of SBA loans, in addition to the lower credit score requirements, is that these are still structured loans that can be repaid on set schedules. Plus, interest rates are still pretty good, since the loans are federally insured. Some extra costs are also associated with these loans, though, including an SBA guarantee fee, and underwriting can be a pain for borrowers who need cash quickly.
SBA loans are best for business owners with good (but not excellent) credit who want to do one or more of these things:
- Buy new facilities or renovate facilities they occupy
- Buy equipment
- Create new jobs
- Develop a new product line
Business lines of credit
If your credit isn't quite good enough or you don't have the revenue necessary to get an SBA loan, you may be able to find the financing you need with a line of credit. This type of loan is called a revolving credit facility, because it allows business owners to potentially borrow the same money multiple times, if they pay back part of what they owe after taking their original loan.
With a line of credit, business owners have a certain amount that they can borrow. They can borrow money against their line as they need it, then repay and actually borrow the same money again, so long as they're still in the draw period (usually the first one or two years of their loan).
After the draw period for a line of credit ends, the business owner repays any amount outstanding on their line, often with fixed payments over five years or more.
While business lines of credit offer a lot of flexibility, they can still be tough to qualify for, because lenders know that the borrower's financials may change and a loan could become riskier over time. Some lenders even include provisions allowing them to call the loan if the borrower's credit score drops or collateral decreases in value – which can cause a business owner a lot of problems if they aren't careful.
Business lines of credit are often used for these purposes:
- Financing midsize purchases
- Renovating facilities
- Smoothing seasonal expenses
- Accommodating recurring financing needs
Merchant cash advances
If your credit is poor and you need business financing, your best bet may not be a loan at all, but a merchant cash advance. This type of financing is available for businesses that process credit card transactions and is extended against future credit card sales. The funder then keeps a portion of future credit card sales or receivables until the advance is paid in full.
Merchant cash advances are pretty unique in the world of business financing. They're easy to get and extremely easy to administer, but they're also expensive, and they're only available to businesses that process credit card transactions or have receivables. What's more, these advances can take a long time to pay back if you experience a period of slow or low-dollar sales.
These are some cases where merchant cash advances may make sense:
- Buying inventory
- Making payroll
- Meeting personal expenses
Bad credit business financing options
If you have bad credit and need business financing, there are other loan options that may work for you. Business lines of credit and merchant cash advances can be quick and easy to get for some, but they aren't an option for all business owners, and they aren't always the best choice even if you can get them.
In addition to the financing options outlined above, here are some that might work if you don't have strong credit:
- Business credit cards: Small business credit cards work just like personal cards and are great short-term financing options for business owners who want to finance everyday purchases.
- Bridge loans: These loans only last for a short term but can be great for businesses who are just waiting to resolve other debt or get paid by customers before refinancing into a long-term loan.
- Personal loans for business: These loans offer a lot of flexibility in use of funds and are one of the best options for startups that haven't been around long enough to meet most lenders' requirements for minimum time in business.
There's also invoice financing or factoring (which allow businesses to borrow against receivables), leasing, equipment loans, crowdfunding, and microloans for very small businesses with very small needs.
Improving your credit to increase your options
If your credit isn't great and you don't have financing options or don't like the options available to you, you can take certain steps to improve your credit. The first thought most people have is to raise revenue, but that's often outside your control. There are much simpler things that are more within your control and will help you expand your financing options.
Here are four things you can do to improve your credit and expand your business financing options:
- Consolidate outstanding loans. If you have multiple outstanding debts, consider consolidating them into a single, structured consolidation loan.
- Pay down revolving lines. Reducing your balances on debts like credit cards can help to lower your credit utilization rate and improve your credit score.
- Keep accounts current. Making sure that you don't fall behind on any of your outstanding debt will also make sure you don't get any new derogatory marks on your credit report and demonstrate to lenders that you are responsible with credit.
- Dispute negative marks on your credit report. If you have old accounts that are closed and have derogatory marks, they may be holding down your credit score. You can work with credit bureaus to eliminate these marks from your credit report and potentially raise your score quickly.
If none are these are options for you, you can always get a co-signer to guarantee your small business loan, or take on an equity partner to get the money you need. No matter your credit, there's always a financing option available to you. Some are better than others, but there are always options.