Getting your small business loan denied can be disappointing. Yet, it doesn’t need to end your entrepreneurial aspirations. Just because one lender said “no,” doesn’t mean the next will. This article outlines common reasons a small business loan may be denied and what to do about them.
Being denied a small business loan is no fun. However, having your application turned down does not mean that your business plan is forever doomed. The first thing you’ll want to do is review the bank’s communication with you about the loan. Looking at it again, prepared for the “no,” you may absorb specifics about why your loan was denied. Otherwise, there’s no harm in calling the advisor you worked with at that lender and asking them to be specific about what you could have improved.
Typically, there are several main reasons a small business loan gets denied. Once you know the issues, you may be able to fix your application for consideration by the next prospective lender. So, here are the top stumbling blocks in getting a loan:
- Poor credit history
- Lack of collateral
- Tight cash flow
- Lack of preparation
- Financing needs are too small
- Poor debt-to-income ratio
- Time in business
Poor Credit History
Just as you personally need a good credit history to land a loan for a mortgage or a new car, this is also a factor in business loans. For small business loans, the lenders will look at both your personal credit score and the score for your business. This number helps them gauge your creditworthiness.
A new business asking for financing without any credit history will have a more difficult time. So, start building a credit history for your business as soon as possible. It involves establishing your business presence by setting up a phone number, business website, and local directory listings to show you are legitimate. Obtain a federal Employer Identification Number (EIN) for tax purposes.
It’s also useful to open a business credit card. Then pay on time every month. This helps demonstrate you can effectively manage business funds.
You might also partner with a vendor or supplier that reports to the business credit bureaus. Again, you’ll need to keep these accounts in good standing for these business relationships to support your application.
Lack of Collateral
Lenders typically need collateral to help guarantee that the loan will be repaid. This means you need to have something that the lender views as valuable. Again, this can be challenging for a small business. After all, you might not own business real estate or have inventory or expensive equipment the bank could sell, if necessary, to recoup its funds. To prove collateral, it’s a good idea to keep detailed records about your assets’ worth.
Depending on your business formation, you may be able to put up personal homes or cars as collateral. However, you may want to think twice before doing so. Keep in mind that if you have to default on the loan, you will lose the asset you used as collateral.
It is possible to get a business loan without collateral. That’s known as an unsecured business loan. Still, these have higher interest rates and more requirements for you to fulfill as lenders are taking a greater risk.
Learn more in this “5 Tips for Using Collateral to Secure a Small Business Loan” article from Inc.
Tight Cash Flow
Cash flow is what keeps the business afloat. If you apply for a loan with low cash flow, the lender could be concerned about your ability to cover your operating costs.
Try these strategies for healthier cash flow management:
- Revisit your terms with vendors to keep your cash in the business longer
- Review your accounts receivable policies to see if you can expedite collections
- Offer incentives to customers who pay early and penalize those who are late
- Look into decreasing your operating expenses
- Pay employees using direct deposit to avoid the unpredictability of waiting for them to cash checks
Lack of Preparation
You may have applied for a business loan before you were ready to do so. Lenders will be looking for you to have a well-written business plan. They’ll also need to see:
- Business bank statements
- Tax returns
- Proof of business registration
- Business licenses and permits
- Financial statements
- Accounts Receivable and Accounts Payable statements
- Information on other business assets and debts
Without this documentation, you’ll see your small business loan denied by most lenders. So, get your paperwork in order before applying.
Financing Needs Are Too Small
You might think it’s easier to get a loan if you ask for less. However, lenders actually want to underwrite larger loans to make more profit from the work they do. According to finance site ValuePenguin, “The average loan extended to U.S. businesses in 2018 was $663,000. However, depending on the type of loan and the lender, averages may range from $13,000 to $1.2 million.”
The way around this? Match your financing needs to the correct type of lender. ValuePenguin tells us, “for loans of $100,000 or more, bank and SBA loans are likely your best option—especially if you need $500,000 or more.” Meanwhile, consider “an alternative lender, a small local bank, or a nonprofit lender for loans under $100,000.” Or, “if you need $50,000 or less, you should consider applying for a microloan through the SBA or a nonprofit microfinance organization—like Kiva or Grameen America.”
Poor Debt-To-Income Ratio
A Small Business Administration article suggests lenders typically “look at some variation of the five C’s: Credit, Character, Conditions, Capacity and Collateral.” The debt-to-income (DTI) ratio falls under capacity. It captures your ability to take on the debt and pay it off.
According to the SBA. “A DTI ratio is calculated by dividing your total monthly expenses, including loan payments, by your gross monthly income. A high DTI percentage suggests that you may have too much debt in relation to your income.”
The maximum DTI will vary by lender, but the lower your ratio, the better. Connect2Capital.com suggests “your small business DTI ratio should be below 50 percent if you want to be considered for a loan.” Aiming for a ratio of around 36% increases your chances of success.
Want help with debt management? Read “How to Deal with Debt When You Work for Yourself.”
Time in Business
Quite simply, you may not have been in business long enough. Some lenders won’t work with businesses that have been operating for less than two years.
Now, that’s not something you can address immediately. If you want to go back to that same lender, you’re going to have to wait longer to reapply. On the other hand, you could look for alternative lending options. You might find an online lender or peer-to-peer lending organization that is more willing to work with your fledgling business.
Landing That Small Business Loan
There are many different lenders out there willing to help fund a small business. So, don’t be disheartened the first time you see that your small business loan is denied. Learn from the experience, revamp your application, and look for a new lender. With determination, you can get your business idea off the ground.
