3 Biggest Questions About Credit Scores Entrepreneurs Need to KnowJanuary 11, 2017
This original article was written by Jared Hecht – @jaredhecht for INC.
If you’re a small business owner, you’ve got a lot on your plate. You manage inventory, employees, and customers every day–you’re probably not looking to add anything else to your to-do list.
But learning the basics of how credit scores work and why you should care could make a massive difference to your small business. It could be what gets you that $50,000 loan instead of that $5,000 one… Or what keeps your business afloat if times are tough.
Thankfully, there’s no need to stress out. Here are answers to the 3 biggest questions about credit scores that matter to your business.
What Exactly Is A Credit Score?
On a fundamental level, your credit score is a measure of how reliable you are as a borrower.
Credit scores take a few different major factors into account and weigh them according to how big of an impact they have on your ability to repay debt. The more you know about your credit and the better you manage your money, the more you can improve your score through thoughtful, prudent financial habits.
The most popular kind of credit score was invented by the Fair Isaac Corporation, now called FICO, and it ranges from a low of 300 to a perfect 850. Everyone has their own rubric for where a “good” credit score becomes an “excellent” one, but here are the general boundaries that most people follow:
Excellent: 781 – 850
Good: 661 – 780
Fair: 601 – 660
Poor: 501 – 600
Challenged: Below 500
The higher your credit score, the more trustworthy you are when it comes to your financial obligations, based on your past actions. Although some people complain that credit scores are unfair, turning subjective judgments into a single number, it’s a system based on an overwhelming amount of historical data. How you acted in the past is a great indicator of how you’ll act in the future–and that’s what your credit score bets on.
So whether you like it or not, credit is a part of your small business’s finances. And as it turns out, working on improving your credit builds positive financial habits for the rest of your business, too.
What Affects Your Credit Score?
If you know what affects your credit score, then you can improve it. If you’ve ever wondered whether you should close that old credit card account or apply for a business loan and a mortgage at the same time, then understanding these factors should help.
1. Your payment history: 35%
As you might expect, when it comes to deciding whether you’ll be a good borrower in the future, your credit score heavily weighs the payments you’ve made in the past.
If you always pay back every business loan, credit card statement, and mortgage bill on time, in full, then you’re doing great. Being on time with your payments is most important, but being on time with multiple kinds of payments is an added plus.
In terms of how a late payment will impact your score, there are two factors taken into consideration:
How late did you wind up making the payment?
How often did you make a late payment?
Delinquent payments stick around on your credit score for 7 years, so while making a late payment isn’t a lifetime offense, it will impact you for a long time coming.
2. Your debts owed: 30%
This category is often called credit utilization as well, and it essentially asks one question:
Of the credit you have, how much is available for you to use?
You can express this as a ratio–the credit utilization ratio–to figure out how much leeway you have with your outstanding debt and credit.
This might seem like an odd factor, but here’s the big idea: the more credit you have that’s still available, the more financial wiggle room you have if something goes wrong. The higher your ratio, the less cushion you have.
For example, if you’ve maxed out your credit limit of $40,000 across your credit cards and line of credit loans, then you have nothing protecting you in case of an emergency. But if you’re only using $5,000 or $10,000 of that available credit, then your credit score will reflect your strategic planning.
3. The length of your credit history: 15%
The more data that FICO has on your borrowing and spending habits, the better they can predict your future decisions. That’s why new borrowers with short credit histories tend to have lower scores–because FICO can’t really label you as trustworthy without enough history to analyze.
A longer credit history will definitely help your score… So long as that’s a history of paying your lenders back on time and keeping your utilization manageable.
Also, your credit history is an average, so be careful when canceling those ancient credit card accounts: they could bring your history length down and potentially lower your score.
4. Your “new credit”: 10%
This category takes into account your credit inquiries or the reports that FICO receives each time you apply for a new kind of credit.
Maybe you applied for a business loan, an apartment rental, a car purchase, or a new credit card. FICO receives a report of your credit getting checked by a lender–and since new credit accounts come with these credit inquiries beforehand, a small drop in your score might happen.
5. Your credit mix: 10%
Finally, your credit mix is just a reflection of the diversity of your borrowing habits.
Making on-time payments with a business loan is great, but making on-time payments with a business loan, a mortgage, and an auto loan is excellent.
You probably don’t want to go out of your way to take on loans you don’t need, so don’t worry: this factor only accounts for 10% of your credit score, and you won’t be penalized much for not borrowing too much all at once.
So Why Should Small Business Owners Care About Their Personal Credit?
This is the big question.
Now that you understand what a credit score is and how it works, why should you care? Especially about your personal credit score, if you’re running a small business?
Your personal credit score will have an enormous impact on your business’s eligibility for business loans–plain and simple. Data shows that higher personal credit scores are correlated with better eligibility for business loans, lower interest rates, and larger loan amounts. The higher your personal credit score, the better business loan you can get, generally speaking.
The answer is deceptively simple. Lenders believe–and the data proves them out–that small business owners’ personal financial habits are often the same as their business habits. If you make late payments on your mortgage, they assume you’ll do the same for a business loan.
One of the best things you can do for your business’s financial borrowing future is to improve your credit score. Don’t wait–get started today.
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