When searching for business financing, it’s all about hearing one phrase: “You’re approved.” After a big post-Recession decline, approval rates in small business lending have quickly picked up speed.
Large banks are now approving more than a quarter of business loan applications, and small banks are approving half of business loan applications. Low unemployment rates, rising costs for companies, and a general sense of optimism among small business owners have contributed to the surge in lending.
Although more companies are receiving financing, there’s a divide on what kinds of terms business owners are getting. Business owners with low credit scores exist on a very different plane from business owners with excellent credit. Using original data from Fundera, as well as data from the U.S. Small Business Administration, we compared loan terms—loan amount, interest rate, and repayment schedule—for the most creditworthy business owners and the least creditworthy business owners.
The differences are stark, amounting to a difference of thousands of dollars to a small business’s bottom line.
Key findings of the report include:
Our results indicate that at least when it comes to obtaining financing, there is a big divide in the business world between low and high credit borrowers across industries. Access to affordable financing is often at the heart of a business’s eventual success or failure, so this data is helpful for small business owners who are thinking of applying for financing. It’s also useful for lenders and financial companies that target a small business audience.
For purposes of this report, we considered creditworthy or “high-credit grade” business owners as those who qualified for SBA loans within the last year. SBA loans are some of the most difficult business loans to qualify for, and the average personal credit score of those who qualify is 693, according to internal data. These are government-guaranteed loans, but the banks and direct lenders who actually issue the loans typically have high eligibility requirements. The “lowest-credit-grade” borrowers are business owners who received loans through Fundera within the last year and had an average personal credit score of 537.
The average American’s credit score has been slowly rising over time, reaching 700 for the first time in 2017. The average small business owner, however, isn’t doing quite that well. The average small business owner’s FICO score on the Fundera platform is 660. That’s considered a good credit score, but also means that about half of small business owners have credit scores that fall short of that. In order to qualify for an SBA loan, bank loan, or other top-tier loan product, you need to have a score closer to 700.
Here are some of the divisions between good and bad credit businesses:
Our study shows that funding amount is a major differentiator between more and less creditworthy businesses. In our survey, the high-credit-grade SBA borrowers received an average loan amount of $423,129, compared to just $20,250 for borrowers with the lowest credit.
The amount of funding you receive is directly tied to the amount of growth your business can achieve long term. Six-figure loan amounts allow business owners to make big investments that pay off and jumpstart growth.
For instance, businesses often use large amounts of financing to invest in the following:
On the low credit score end, the borrowers who received just around $20,000 won’t be able to go very far. That’s far below the credit limit on many business credit cards. The average business owner has a total credit limit on credit cards of over $50,000.
Microloans—defined as loans under $50,000—are helpful in incrementally helping a business grow. You can invest a small amount of money in one project, and with the profits from that, invest in another project. However, with rising corporate costs, small dollar loans are not as likely to make a meaningful dent for a small business, and they are not as likely to result in fast company growth.
Ultimately, the real benefit or bite of a small business loan comes from the cost. Like any lender, business lenders obviously make money by charging interest and fees. But typically, business loans have higher interest rates than home loans and consumer loans. Businesses have high failure rates, so lenders charge higher interest to account for the risk. That’s particularly true now, as interest rates across the economy rise.
That said, within the business loan space, there’s a wide range of interest rates. In our analysis, the segment of high-credit, SBA borrowers received an average interest rate of 7.27%. Borrowers with the lowest credit scores, in contrast, had an average interest rate of 67.88%.
What does that difference mean in real terms? Let’s say you borrow $100,000 at a 7.27% interest rate for three years. Ignoring fees for a moment (which you’d need to calculate the loan’s annual percentage rate), your total borrowing cost would come to $11,603. In other words, you’d being paying back the lender $111,603.
Instead, if you borrow $100,000 at a 67.88% interest rate for three years, your total cost would come to $136,227, more than 10 times the cost of the previous loan. That means you’d have to pay back the lender a total of $236,227, more than double the initial loan amount.
Having too much debt increases the odds of business failure. Money goes to the passive activity of repaying debt, rather than an active, income-generating activity, such as hiring new staff or advertising a new product. In addition, the more debt you have, the higher your debt service coverage ratio will be. That means a larger share of your business’s income goes toward paying back debt. When more revenue is tied up in debt service, it’s harder to qualify for financing and to convince investors to invest in your company. So, what starts out simply as a more expensive loan product can end up as a longer-term financial problem for your business.
After loan amount and interest rate, the other major characteristic of a business loan is the length of the repayment term. The longer you have to pay back a business loan, the smaller the size of your monthly payment, which helps you conserve cash flow. Short-term lenders deduct payments from a business’s bank account on a weekly or daily basis, which can disrupt a small business’s cash flow.
At first, micropayments might not seem like a problem, but they can quickly put your business under pressure if you’re not generating enough cash to keep up with the successive withdrawals. In fact, 82% of business failures can be attributed to cash flow problems.
In our study, creditworthy businesses qualified for an average loan term of 11 years, with a monthly payment frequency. Less creditworthy borrowers qualified for an average loan term of just eight months, with a weekly or daily payment frequency.
A short repayment time frame isn’t always bad. Borrowers pay off short-term loans and lines of credit in fewer than 18 months. Since the borrower holds on to the loan for a very short time, the total amount paid in interest over the life of the loan is relatively low. In contrast, an SBA loan has a lower interest rate, but you continue to make small payments over several years. That means you’ll pay relatively more in total interest over the long run.
On a $50,000 loan with a 7.27% interest rate that’s paid monthly over an 11-year period, you’ll pay a total of $22,582 in interest. On a $50,000 loan with a 67.88% interest rate that’s paid weekly over an eight-month period, you’ll pay a total of $33,940 in interest. Given the big difference in interest rate, the difference in total outlay of interest isn’t that large.
At the end of the day, short-term loans limit interest from accumulating too much. However, they also prevent you from being able to divide up your monthly payments. That can put big investments, such as constructing a new building, out of reach for a small business.
The data in this study comes from two different sources. Data on borrowers with credit scores under 600 comes from a subset of small business owners who applied for a loan on Fundera within the last year. The sample size for this data is 173 business owners and spans November 9, 2017, to November 9, 2018.
Data on the most creditworthy borrowers comes from the U.S. Small Business Administration. The data spans borrowers who received SBA 7(a) loans from September 30, 2017, through September 30, 2018. The sample size is 60,384 businesses.
Credit is obviously very important when applying for business loans. It can mean the difference between getting the money you need to grow your business and receiving a rejection letter. But it’s more important than that. It can mean a difference of thousands of dollars in initial access and thousands of dollars to your bottom line.
This is important information both for small business borrowers and for companies that market products to small business owners. As a small business owner, improving your credit by 50 to 100 points might mean that you have to delay your search for financing by a few months while you get your finances in shape. But the payoff is worth it.
Priyanka Prakash is a senior contributing writer at Fundera.
Priyanka specializes in small business finance, credit, law, and insurance, helping businesses owners navigate complicated concepts and decisions. Since earning her law degree from the University of Washington, Priyanka has spent half a decade writing on small business financial and legal concerns. Prior to joining Fundera, Priyanka was managing editor at a small business resource site and in-house counsel at a Y Combinator tech startup.