The Effect of Credit Scoring on Small-Business Lending
Credit scoring, according to Ron Feldman, a senior financial specialist at the Federal Reserve Bank of Minneapolis, “is the process of assigning a single quantitative measure, or score, to a potential borrower that reflects the borrower’s relative chance of going into delinquency or default.”
Small business loan lenders use credit scoring in determining whether to deny or extend credit. A credit score is critical and influences many financial transactions, including credit cards, mortgages, auto loans, and private loans.
A credit score is measured using a number ranging from zero to 850. An individual’s credit score ranges from 300 to 850, with 850 being the highest possible score. Small businesses’ credit score ranges from zero to 300, with 300 being the highest possible score. According to Lisa Xiong, “Your credit score and history are some of the most important factors in getting a small business loan.”
An individual’s credit score is largely determined by their payment history, new credit, length of credit history, the amount owed, and credit mix. The information on their credit report determines a business credit score, including historical business data, company information, public filing, business registration details, among others.
According to Lantern by SoFi, “FICO scores range from 300 to 850, and the average credit score in America in 2020 was 711. That’s considered “good,” so if you’re close to that number (or even if you aren’t) there are a few steps you can take to help maintain and even improve your score.”
Lenders use this information in risk-based trello enterprise pricing, where the probability of repayment determines the loan terms, including the interest rates offered to the borrowers.
How to Establish Your Business Credit Scores?
Many people use their credit cards for their business expenses, and the payments end up as personal credit reports. Business models generate credit scores based on the owners’ personal and business credit history combined with other business financial information.
The following steps are critical in establishing credit for your business. The credit generates data that is then used in generating credit scores
- Form a limited liability company or incorporate your business:
- Enlist for a federal employer identification number from IRS
- Open a bank account for the business
- Get a business phone line under the legal business name.
- Register to get a D-U-N-S number from Dun and Bradstreet:
Credit scoring, once established together with loan standardization, helps evaluate the risks associated with lending. Credit scoring alters small business lending in three ways. They include the loan pricing, interaction with borrowers and the lenders, and the availability of credit.
Interaction Between Borrower and Lender
Before credit scoring, a small business owner looking for a loan has to submit an application to the loan officer together with other documentation. With the introduction of credit scoring, the loan process bypasses all these processes and eliminates the need for such interaction.
Today, a lender doesn’t need to know the business owner before lending to them. The lender goes through the small business credit score and determines whether he wants to invest.
A business with a high credit scoring will receive a low price for its loan; it will also have a pool of lenders reaching out and offering to lend through direct marketing. Through credit scoring, a business traditionally believed to be high risk could be classified as low risk.
However, not everyone gets a price reprieve through credit scoring. A business that requires a full-scale human review faces higher costs for its loans. these businesses also suffer the burden of fixed costs incurred by traditional underwriting
Credit Availability for Small Businesses
Information about how the small business intends to pay back the loan allows the lender to price the loan according to the risks expected. This significantly increases credit availability to small businesses. Credit scoring also plays a critical part in attracting a big pool of funds available for small businesses.
Data availability helps the scoring system securitize the business loans, and a big pool of lenders and funds opens up once the business loans are securitized. Through securitization, small business loan lenders ready to invest in asset-backed securities will have an opportunity to avail their funds and offer loans.
How Important Are Credit Scores?
In today’s world, credit scoring is critical for every small business requiring loans. If you don’t reach a certain threshold, you will not be successful in securing a loan.
When it comes time to weigh your options, be sure to compare all the lenders available to ensure you’re getting exactly what you need.