Credit is a tool for business akin to any other assets. Obtaining access to monies for investment or covering cash flow problems is a tremendous advantage, especially if the cost of that money is not prohibitive. Easy access to money (perhaps too easy) was one of the driving factors in the balloon economy of the first decade of this century.
The collapse of that economy and the financial institutions that propelled it by selling questionable loans as securities has led to a new world in business in which banks are difficult to deal with, loath to fund any but the most credit worthy borrowers, and access to money now can allow a tremendous advantage against competitors or allow purchase of recession reduced assets.
Or keep you in business.
And personal guaranties have become essential for more and more business loans, thus personal credit records can become a vital aspect of one’s ability to fund both business and personal debt.
In this new environment, and for the next decade of recovery, it is therefore critical to develop, maintain, and understand the tools used by the various financial institutions to review and gauge one’s credit. This article shall briefly outline the criteria often used in this Brave New World.
For many entities banks utilize a ratio methodology of debt to assets/income and apply it to the industry and local conditions to determine whether a business is credit worthy and the amount and terms of any line of credit. Equally important are trends. Even solvent companies can find their credit line being restricted or removed if the trend over the last year was negative with no apparent sign of let up.
The Line of Credit agreement normally assigns debt to asset ratios which will be applied and if not met the borrower is in breach and the Line of Credit can be eliminated immediately with all sums due and payable at that time. Indeed, most such agreements also give the bank discretion to eliminate the credit line for any or no reason at will…though that is unlikely absent poor ratios. Most banks have access to the financial statements of any company borrowing or can demand delivery of same at will.
And once they receive the financial statement, if the ratio is wrong, even a solvent company with a good record of paying all its debts can receive the dreaded letter. We see it happen to clients all the time.
This can be extremely frustrating to companies that have paid their debts religiously, have no credit litigation outstanding, and are already struggling to make it, then suddenly hear from their bank that their credit line is cut in half or even eliminated. In most instances, the banks offer a pay down method for the already existing line and our office often hears from irate business owners asking how this can be.
Banks base their decisions on mathematical formulas that please the home office and the regulators. Most banks do not have room for local office discretion though some, such as Bank of the West, normally do give some local discretion. Cross the debt to asset ratio, and a set of procedures within the bank begin which are almost entirely automatic.
What is that ratio? Most credit line contracts are not read closely by the business. They care about amount and rate and the other wording is extremely difficult to master. Since the banks indicate they are not about to change their “form” contracts, most business owners do not obtain legal advice about the terms and simply sign on the dotted line. As such, once they read the fine print they normally discover that the bank is free to use its own discretion to decide what is an acceptable debt to credit ratio and can alter that at will. Even if the ratio is set in the agreement, the banks normally place ratios in there that are missed in any downturn.
At which point the bank can insist upon tougher terms, pay down of all or part…or cancel the entire line.
In good times, they usually simply demand more security (personal guaranties) and lower sums outstanding on the line. In bad times they can and do cancel the entire line.
Guaranties from the owner of most limited liability entities are also typical which leads to the second part of this article-the criteria for individual credit lines. See our article on Guaranties in CaliforniaTransactions for a complete discussion of the dangers associated with those.
For most people in the United States, the term “credit score” often refers to the FICO score, a number
based on a formula developed by the Fair Isaac Corporation. Fair Isaac looks at a summary of all your credit accounts and payment history. If you have a mortgage, a MasterCard or a Macy’s account, it will be included in the report, as will late or missed payments.
FICO scores range from 300 to 850, and Fair Isaac calculates them for each of the three big credit-reporting agencies: Equifax , Experian and TransUnion. That is one reason why your FICO score with each may differ slightly. Generally speaking, the higher your score, the more money you can borrow and the less you will pay for the loan.
Here is how your score is determined:
1. 35 percent is determined by your payment history. Do you regularly pay your bills or fines on time to any creditor that submits your information to the credit bureau? Even unpaid library fines, medical bills or parking tickets may appear here.
2. 30 percent is based on the amounts you owe each of your creditors, and how that compares with the total credit available to you or the total loan amount you took out. If you are using all of the possible credit on your credit cards, your score may suffer.
3. 15 percent is based on the length of your credit history, both how long you have had each account and how long it has been since you had any activity on those accounts. The fewer and older the accounts, the better, assuming that you have made timely payments and have no history of disputes.
4. 10 percent is based on how many accounts you have recently opened compared with the total number of your accounts, as well as the number of recent inquiries on your report made by lenders to whom you have applied for credit. Your score can drop if it looks as if you are seeking several new sources of credit which is seen as a sign that you may be in financial trouble. (If a lender initiates an inquiry about your credit report without your knowledge, though, it should not affect your score.) Shopping around for an auto loan or mortgage should not hurt, if you keep your search to six weeks or less. But every inquiry you trigger when you apply for a credit card can affect your score
5. The final 10 percent is determined by the types of credit used. Having installment debt like a mortgage, in which you pay a fixed amount each month demonstrates that you can manage a large loan. But how you handle revolving debt, like credit cards, tends to carry more weight since it is seen as more predictive of future behavior. Example: if you pay off the balance each month or just the minimum or charge to the limit of your cards or rarely use them.
For the best rates on a loan or credit card, you want a score that is above 700, at least. How to create it is obvious from the criteria above.
It is vital to pay all your bills on time. It is also a good idea to have at least one credit card you plan to use for a long time, but not too many. Keep a low balance ( generally less than one-third of your total credit limit. ) It is best to pay off your balance entirely each month.
And stay on top of the information in your reports. You can get a free copy of your credit report from each of the three major credit agencies once a year. Be sure to order it through annualcreditreport.com, the only authorized online site under federal law.
If you notice information that is inaccurate, you can submit a request for removal online at Equifax,
Experian or TransUnion. You can submit your request by mail.
Be sure to specify what information you think is inaccurate and why, and include any documents that support your argument. Ask in writing that the information be corrected or removed from your report. By law, the bureaus must investigate your complaint, usually within 30 days, and give you a response in writing (or via e-mail, if your request was made online) and a free copy of your report, if the information is changed as a result. Your score should reflect that change shortly after.
To see your actual score, one normally has to pay. You can go through Equifax, Experian or TransUnion directly, but be aware that the score you order may be one developed by the agencies themselves, like the TransUnion TransRisk New Account Score, Experian Plus or VantageScore. These are different than the FICO scores lenders generally use when they evaluate your loan applications.
Myfico.com offers two reasonably priced options on its site. Whether you need to monitor your credit very often is debatable. For most, a close look at the free annual reports from each bureau is probably enough. But if you plan to apply for a loan or credit card, check your score and report at least a couple of months beforehand.
See our article on Credit Report Problems-What Are your Rights Under Federal Law for a more complete discussion of remedies.