Business credit behavior can affect the important loans in your personal life.
Small business entities under the category of sole proprietorship routinely use the business owners’ personal social security number as the business’ tax ID number. Those nine digits are the only numbers available for business credit applications, such as commercial bank loans, corporate credit cards, and many other lines of credit with vendors who provide everything from coffee and water to the actual widgets needed for the business to resell.
Sole Proprietorships & Personal Credit
A good credit score is an important part of an individual’s fiscal health, but if also extended to the overall financial health of their business, individuals may be asking a bit too much from nine numbers stressed by the multitude of financial transactions an individual and a small business will inevitably incur. Operating this way in the long term could put the business owner’s credit score at risk, especially if the business’ revenue and profitability fall to dangerously low levels.
Most business owners consistently look for ways to improve their business’ profile and their creditworthiness. Sole proprietors should know that in the eyes of banks and other lenders, their personal credit profile and business credit profile are closely linked. It’s critically important as a sole proprietor to take the appropriate steps to protect both. Business owners should seek professional advice on monitoring, evaluating and protecting their credit standing just as they would protect any other business or personal asset.
The answer may seem obvious, but one key to success is to not use personal credit to finance business purchases. Doing so may result in financial obligations being reported on your personal credit history. To completely separate the two, owners should establish their business as a legal entity that does not hold them personally accountable for the transactions of their business. There are more than a few types of business entities from which to choose to change the legal status of a small business.
It is highly recommended that you consult with an attorney and a state or local business program that advises entrepreneurs as to the best course of action if you want to ensure a long-term commitment to your business. In an eBay economy, many individuals in the last few years have chosen to supplement their regular W-2 income with a business on the side. Those part-time owners will also want to pay close attention to the stress they may be placing on their personal FICO scores. Depending on the profitability and activity of these businesses, it may be advisable for some to transition their “business on the side” to a legal entity.
Deciding to Incorporate
There are a number of ways to change the legal status of a business (see table on page 30). The main benefit is to create what is typically called a “corporate veil of protection” for the business owner, which will allow some protection from the debts of the business should it fall on hard times. As we’ve mentioned, all entities except a sole proprietorship will give the owner a new business tax ID number to begin the separation of the credit of the business and the credit of the individual.
As the business begins to switch all vendor relationships to the new tax ID number, the personal credit score of the business owner should also begin to rise. A business credit report will then become established on the business with the new tax ID. That report showing whether or not the business is creditworthy will now be the primary tool for determining approval for all business credit applications going forward.
The Personal Guarantee
Business loans for businesses with a legal entity—especially loans for start-ups—may sometimes require a personal guarantee to qualify for a business. It’s important to become familiar with the credit reporting system of the lender with regard to the use of the borrower’s personal social security number. It may not be a foregone conclusion that the lender will choose to report the credit information to the respective credit bureaus. This service costs lenders money, and they may only be inclined to send in a report if the loan is headed for delinquency. It’s important to read the terms and conditions, and ask about the procedures ahead of time. For some, it may be an important motivator to pay the business loan perfectly on time if their personal credit score looms over the loan.
Remember, if a business owner is about to refinance his or her home, just a few points on your credit score can make a huge difference in the ability to take advantage of the current environment of low interest rates. A lower interest rate can save you thousands of dollars over the life of your mortgage loan, which is something every savvy business owner needs to know. iBi
George DeMare III is managing partner of Midwest Mortgage Capital. For more information, visit midwestmortgagecapital.com.