by Meredith Wood, Editor-in-Chief at Fundera
When most of us imagine applying for a business loan, we probably think of driving down to the local bank where we’ve done business for years, speaking with a loan officer, and going through the loan application process with that known and trusted lender. Unfortunately, though, brick and mortar banks have undergone a lot of changes since the 2008 recession — one of the biggest ones being their willingness to fund small business loans.
There’s no denying that traditional bank loans remain the lowest cost debt financing that exists for businesses — so, in most cases, if you can qualify for a bank loan, you should absolutely go for that option. That said, the application process for bank loans tends to be exhaustive, and the rejection rate is high.
To avoid wasting precious time, consider these five factors before you apply for a bank loan:
1. Your Personal Credit.
Because most small businesses don’t have a significant business credit history, bank lenders will rely on your personal credit history as the business owner as the primary factor in determining your eligibility for a business loan. To determine this, the bank will pull your personal credit report for one or more of the three major FICO credit reporting bureaus — Experian, Equifax, and TransUnion.
If your credit score in the 700+ range, you should be in great shape! If not, though, it will take a miraculously impressive financial record in all other areas of your business—along with a compelling explanation of your less than stellar credit score—for a bank to even consider approving your business loan application.
2. Your Business History.
As we mentioned, it’s not uncommon for startups to lack a documented credit history — but that doesn’t mean that banks don’t care about your business’s past financial dealings. Along with checking with a business credit reporting agency like Dun & Bradstreet for any record that might be available, the bank will ask to see your bank statements, balance sheets, profit and loss statements, and tax returns from the past two fiscal years.
Have you been in business for less than two years? This, unfortunately, will also work against your bank loan application, as banks know that the longer you’ve already been in business, the better your chances will be of leading your business to success through the life of your desired loan.
3. Your Funding Needs.
If you haven’t already done so, take some time to forecast the budget you’ll need to achieve your business goals. Before applying for a bank loan, you should be prepared with a dollar amount that you’re looking for that will allow you to complete your needed project while also leaving you with manageable loan payments, even if one or several unexpected business expenses arise.
A great way to figure out what size loan you can afford is to calculate your debt service coverage ratio (DSCR). This formula will show you how much cash you have remaining after all your monthly expenses are paid, which is helpful in determining whether you’ll be able to meet the extra cost of your desired loan. Here’s the formula to use:
4. Cash Flow/Loan Payment = DSCR.
When it comes to your ratio, the higher, the better. The best thing about the DSCR is that it’s also the formula that lenders use, so you can know in advance what they’ll be seeing. As you consider your result and the size of loan you can afford, keep in mind that most bank lenders will require a DSCR of at least 1.5 to approve your loan.
4. Your Available Collateral.
Even under the best of circumstances, small business loans are considered a risky investment for lenders. For this reason, most banks will require substantial collateral to secure your loan.
Collateral can come from either your business or your personal assets and can take many forms, including your family home or other real estate, your retirement accounts, business or personal vehicles, or equipment or inventory you use in your small business’s operations. Keep in mind that the amount of funding you can obtain may be directly proportioned to the collateral you have available, so if you’re applying for a particularly large business loan, you’ll need to come up with the collateral to match that need.
5. Your Alternative Options.
If the reality of the requirements involved in obtaining a bank loan has you feeling hopeless, there’s good news! The post-recession financial climate has brought about a host of new small business financing options from online alternative lenders, giving you a much better chance of obtaining the funding your business needs. Though online alternative loans do tend to be more costly than traditional bank loans, there is a wide array of affordable options to choose from — even for applicants who aren’t likely to qualify with (or even were already rejected by) a traditional bank.
Meredith Wood is the Editor-in-Chief at Fundera, an online marketplace for small business loans that matches business owners with the best funding providers for their business. She is a resident Finance Advisor on American Express OPEN Forum and an avid business writer. Her advice consistently appears on such sites as Yahoo!, Fox Business, Amex OPEN, AllBusiness and many more.