There’s a lot for a small business owner to think about when preparing a business loan application.
But before you begin to compile documentation, take a step back and ask yourself — “Can I afford to apply for a loan?
Can I afford the repayments?
Does my business have the revenue to actually make the loan payments?”
In short, do you have the ability to pay for this business loan?
Asking these questions will help you think about the loan process from the lender’s point of view.
Can You Pay Back the Loan?
Most lenders use varying tools to determine if your business is worthy of a loan, and whether or not you can, in fact, pay it back.
One tool is a debt service coverage ration (DSCR), which compares the cash that you have available as a business owner (to pay back the loan) and the amount of money you hope to borrow per year, including interest.
Generally, banks are more comfortable offering assistance to businesses that have been in existence for a number of years and have a proven financial track record.
If your business has consistently made a profit and that profit can cover the payment of additional debt, it is likely that your loan will be approved.
If however, your business is a startup or has been operating marginally and has an opportunity to grow, you need to prepare a thorough loan package with a detailed explanation including how the business will be able to repay the loan.
More Importantly, Will You Pay Back the Loan?
Lenders look at more than your business’s finances when they evaluate your loan application. They will also look at you, the business owner, and will likely use another tool to determine your personal aptness for a loan — your debt-to-income ratio.
They’ll evaluate your monthly personal debts (including things like credit card payments and car loans) as well as your housing expenses (mortgage payments as well as homeowners insurance, property taxes, etc.). They’ll divide your total monthly debts by your monthly gross income to get a percentage.
Most lenders prefer debt-to-income ratios under 36 percent.
You can get a step ahead here by calculating your debt-to-income ratio yourself to see if your income far exceeds your debts. If it does, a lender may add some of the excess income to your business’s available cash, which can be helpful for businesses with DSCRs that need a boost.
Lenders may also use your personal credit score to decide if you are worth the risk, ensuring that you have a history of paying your bills. Banks and other traditional lending institutions may place a greater emphasis on credit scores, so if your personal credit isn’t great, you may want to look for other, alternative loan options that are more flexible.
Be Sure to Ask Yourself, “What If?”
Even if you know that you can and will pay back your loan, you have to consider the toughest question of them all — what would you do if you can’t pay it back?
Even with the best intentions and responsible planning, all business owners must have a plan in place in case the business does not work out. A typical backup plan might include assets or collateral that the bank can claim if you’re unable to pay back your loan, or an extra source of cash float that can go toward loan payments.
For many small business owners who don’t have that cushion, the backup plan could be what a lender might call a “personal guarantee” — a promise that if you can’t pay back the loan through your business, you’ll pay it out of pocket.
It goes without saying that assuming personal responsibility for business debt comes with a lot of risk, so be sure to consider your decision carefully. If every single part of your business plan would have to play out perfectly in order for you to pay back your loan, then it may not be time to apply for one yet.
Once you can address the questions above, you’re ready to decide if you should move forward with the loan application process.
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