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A common misconception around franchise lending is that a potential franchisee candidate with a good credit score should have no problem securing a loan. This is NOT TRUE!
An individual’s credit score, along with a favorable financial history, is only one of the four main qualifiers lenders analyze before making their loan approval determination. Personal equity injection, collateral, and cash reserves for nine to 12 months (to cover loan and lease payments, start-up costs, and personal expenses) make up the remaining qualifiers, and all are considered when reviewing a loan application.
From our experience, the cash reserve requirement is the area where most issues arise. A lender’s ultimate concern is the repayment ability of the borrower – and if that borrower isn’t sufficiently capitalized during the ramp up period (typical start-ups take over seven months to breakeven), the loan has a serious risk of defaulting.
The cash reserve requirement ensures the lender that the borrower can cover all of their business and personal expenses OUTSIDE of the proceeds of the loan. This means the borrower either needs to have an outside source of income that can cover these expenses or a sufficient cash reserve, and the funds to cover this period must be identified to the lender in the loan application.
The personal equity injection is another area that often causes problems. Lenders want to make sure the borrower has “skin in the game” as another way to ensure repayment. Typically, the borrower is asked to provide 20-30% of the total loan amount, and then the lender will loan them the rest. So, for a $100,000 loan, the borrower would be asked to put up $20,000, then the bank would loan them the remaining $80,000.
A lot of new franchisees don’t necessarily have that amount of cash on hand (even with a great credit score), but may have enough in their retirement account. This is why we often assist our lending clients with executing a 401k/IRA rollover to provide the equity injection for their loan.
It is important to consider all of these qualifiers when determining the viability of a potential franchisee to secure financing, because the credit score is only one piece. You don’t want to get to the end of your sales process with someone only to find out they are unable to provide the equity injection or insufficient cash reserves. We recommend sending your franchisee candidates over to us as soon in your process as possible so that we can pre-qualify them with FranScore, giving you a reliable answer on the likeliness of them being funded.
5 Things That Impact Your Credit Score
The Fair Isaac Corporation (“FICO”) is the de-facto standard in credit score reporting and the agency most lenders rely on; a FICO score of 720 or higher is considered to be “strong” and any score under 680 to be “weak”.
And while we just talked about how the credit score isn’t the only factor in determining a candidate’s ability to secure financing, it is still a litmus test for many lenders. Any score below 680, regardless of the individual’s other qualifiers, will make it significantly more difficult for that person to be approved for a loan.
At its core, a credit score is simply a representation of your reputation; it informs a potential creditor of how responsible you have been with credit.
But a low credit score isn’t always due to poor financial responsibility. For example, a recent college graduate who’s never had a credit card before will have a low credit score, but will also be given a chance by creditors to prove themselves. Conversely, an elderly individual who’s paid off their mortgage, cars, and other debts will also have a low score because they’re not using credit.
If you feel your credit score may be a hindrance to your approval, here are five factors you can control that impact your FICO score:
1. Payment History
According to FICO, 35% of your score is made up of your payment history. Late payments on credit cards, mortgage payments, and other debts can drop your score 100 points or more. Though these missed payments remain on your credit report for seven years, you can decrease their importance by improving your repayment performance.
2. Outstanding Debt
Outstanding debt accounts for 30% of your credit score, and owing a large amount on credit cards and loan payments can reduce your score. The issue comes not from the amount you owe, but rather the amount of your available credit you are using. For example, if two people with the exact same financial history each had a credit limit of $20,000, but one owed $18,000 and the other $5,000, the person owing $18,000 would have a lower credit score. You should aim for keeping your credit card balances between 15-25% of your available credit. Debt to credit ratios consistently over 30% may cause your credit score to decline.
3. Length of Your Credit History
The length of your credit history (how long you’ve had credit), makes up 15% of your FICO score. Simply put, the longer your credit history, the better your score will be. This is determined by formulating the age of your oldest account, the age of your newest account, and the average age of all of your accounts.
4. Age of Your Credit
The age of your credit constitutes 10% of your FICO score. While the length of your credit history (#3) looks at your entire credit history, this measurement looks at the age of your current accounts. FICO looks at how many new accounts you’ve recently applied for and the last time you opened a new account to formulate this portion. Avoid opening lots of new accounts at once or even within a year; too many credit cards will be viewed negatively.
5. Types of Credit in Use
The last 10% of your FICO score considers your mix of credit. The formula analyzes the total number of accounts and then factors in the “mix” of different credit types, such as credit cards, store accounts, installment loans and mortgages. The thought is that the better you are at managing an array of different credit lines, the more responsible of a borrower you might be.
Bottom line, your credit score is a big factor in getting approved for a loan, and obtaining the best available interest rates, but a high score isn’t a guarantee of approval nor a low score an automatic denial. Keeping a healthy score should be something you are regularly aware of and taking steps to rectify a declining or low score an important obligation. If you manage your credit responsibly, your FICO score will reflect that effort.