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Explore Our Blog Series On The 3 C's
Credit, Cash Flow, Collateral
Overview of Credit Relating to Personal Finances
What is Credit?
Credit is a contractual agreement in which a lender lends money to the borrower with the intent to pay the lender back at a later specified date (usually with interest). Credit is the purchase of goods or services with money that you do not yet have in your possession, but have the intent to pay back to the lender once you receive the money. When buying groceries with a credit card, you are using credit. Getting a loan to buy a car or a house is also utilizing credit.
Why do you need credit?
Lenders look at your credit score to see how likely you are to pay them back. Buying items such as houses or cars may require you to get a loan, and the lender will look at your credit score to see if it is a good investment to lend you their money. Your credit score may even be used in the hiring process or by landlords, and will also affect your loan interest rates.
What is your Credit Report/Score?
Your credit score is a three-digit number that represents your credit history and trustworthiness. Lenders use that three-digit number to help determine how you will use their credit line based on your financial history. The range is 300-850, with 850 being the highest score available. Most credit scores fall between 600 and 750. A credit score above 700 hundred is considered a good score, and a score above 800 is considered excellent. A credit score or FICO score is created based on five different criteria which are debt utilization, payment history, types of credit used, new credit, and credit length. From these five factors your three-digit credit score is created, and that number is what lenders look at to see how likely you are to pay them back and if it will be on time or late.
How do you Build/Improve Credit?
Like losing weight, it takes time and there is not a quick or simple solution for it. To help improve your credit score, make sure you pay current debts on time. Late payments are an easy way to decrease your credit score. To assure that payments are on time, you can set up payment reminders through online banking. You can also set up recurring payments, which are scheduled when a payment is due, and your online bank will automatically take the minimum or set payment out of your account. Some believe this is not a good idea because it does not help you improve your money management skills or time management skills for making regular timely payments. Another step to take that will not necessarily improve your credit score but it will give you peace of mind, is to decrease your debt and over spending. You will need to create a budget that is geared to putting all extra money, except for necessities, towards paying off your debt. It is best to pay off debt with the highest interest rate first, and then work your way to paying off the less expensive interest accounts. Debt consolidation programs can be beneficial for those that seek to simplify their payment plan. An important strategy is to limit yourself from opening any new lines of credit. Opening new lines of credit will actually lower your credit score especially when you have outstanding debt.
Building and Repairing Business Credit
Building business credit helps to separate your personal credit history with your business’ credit history. That way you can benefit from having good business credit even if your personal credit history is lacking. In other words, if your personal and business credit are separate, and your personal score falls, then your business credit will be protected and vice-versa. Having business credit allows the owner to keep their personal assets protected as well. Keeping separate accounts allows for clear cut budget analysis, more straight forward record keeping, and protection for each individual score in case of an unforeseen hit on either account.
Having good business credit has many benefits. One of those benefits is that you have better interest rates and credit terms when applying for loans from lenders and banks. Good business credit also helps to position your company for better payment terms with your vendors and suppliers. Another benefit is that it will help you reduce the number of times that you are required to prepay for services or products your company needs to operate and grow.
It is still important to make sure that your personal credit is in good shape. With young businesses that do not have a lot of credit history, lenders may check the owner’s personal credit as well as the business credit when applying for a loan. Therefore, the health of both personal and business credit are important to maintain.
The first step that needs to be taken when you want to start building credit as a business is to incorporate your business. If the business is a sole proprietorship or partnership, then the credit history is the same as the owner(s). When the business is incorporated it separates the owner and the business. Forming a Limited Liability Company (LLC) is a form of incorporation which legally separates the owner’s assets and the business. The next step should be to get a federal employer identification number (EIN) which is used for federal tax filings. The EIN is simply used like a social security number for your business, and is required to open a bank account in the name of the LLC or corporation. After obtaining the EIN for your corporation or LLC, you can open a checking account under the business name.
Now that the business has taken its own identity and is separate from the owner, you can treat the business as a separate person. You will want to pay expenses or transactions of the business from the business account. When looking for a business credit card, it is important to pick a company that reports to the three major agencies. Opening a business credit card is one of the best ways to build business credit. Having a business phone number in your business’ legal name is another aspect that supports fostering the identity of the business.
Opening a line of credit with your vendors/suppliers can be mutually beneficial for both parties. Find vendors/suppliers that report to credit agencies so the positive transactions will be reflected on your score. A line of credit is revolving credit that you can borrow, repay, re-borrow, and then repeat this cycle if there are funds available. After opening a line of credit, confirm that the vendor is reporting your payment history to the three credit agencies.
Experian, Equifax and Dun & Bradstreet are the three reporting agencies for business credit. For personal credit scores the three reporting agencies are Experian, Equifax and TransUnion. Opening a credit file is an important way to monitor your credit, and it is recommended to check your score once a year for possible fraudulent activity. It is very easy for a business to check it’s credit score. The business can pay a fee to any of these bureaus and a full copy of the business report will be provided.
If a business has a credit score that has been damaged, there are steps you can take to repair the score. One of the main reasons business credit is low is due to late or missed payments. Making payments on time will not only stop your credit score from decreasing, it will begin to improve your credit score. Early payments will give you an even better credit score than if you just make payments on time. If you have a past due account, you may be able to rectify this if the creditor or lender is willing to negotiate. Some lenders may remove all negative marks from your account if you make a certain amount of payments on time. This all depends on the negotiation and mercy of the lender since they have no obligation. Having more than one account is a good idea to build credit as long as you are careful not to overextend your resources, creating undue liability for your company.
Reducing revolving credit is another step that should be taken. Lenders look at the credit utilization rate, which means they look at the debt to credit ratio. Say your credit limit is $5,000 and you owe $2,500; you have used up 50 percent of your available credit, which will actually decrease your credit score. The higher the ratio, the higher the risk, and the lower your overall score. You want to keep the percent of used credit (debt) under 30 percent or only charge what you can payoff every month.
Closing the accounts will not help improve your credit score, in fact, it will actually hurt your credit score. Open and keep accounts. If you have not used an account in a while, make a small purchase and pay it off right away, but keep the account open.
Cash Flow and What it Means for Your Funding Opportunity
Cash flow is the total amount of money that is going in and out of a business, especially if it effects liquidity. In other words, cash flow can be looked at as the total net amount of cash-equivalents and cash flowing in and out of the business. The basic objective of financial reporting is assessing the timing, uncertainty, and amount of cash flow. A cash flow statement reports investing, financing and operating cash flows. Simply put, a cash flow statement measures how well a company can manage its cash position. Which means it measures how well the company can generate cash to fund its operating expenses as well as the ability to pay its debts off.
A positive cash flow means that the company is robust and making profits. The company’s liquid assets are increasing which allows them the ability to reinvest in their company, pay back shareholders and expenses, and provide a barrier of protection when future financial challenges arise. The company must have enough cash or cash-equivalents to be able to handle short-term liabilities. This flexibility is what creditors and investors look for.
The key to making sure that your company does not struggle is to avoid having a lot of profits tied up in accounts receivable and inventory, or overly devoted to capital expenditure.
Why Use Collateral for the Loan Process?
Having collateral to offer lenders helps secure better loan terms because it increases creditworthiness. Collateral allows for a higher loan amount, lower interest rates and longer repayment terms if desired. Should you default, offering collateral upfront gives you greater control on what may be seized.
Collateral is something that is pledged as an asset to the lender if the borrower defaults on the loan. A loan that has collateral involved is called a secured loan and normally has a lower interest rate since it is backed by the collateral. There can be many things offered as collateral but the most common are houses, cars, savings accounts, and investment accounts. For example, mortgages are loans that have houses as collateral and car loans have the car as collateral.
In regards to capital funding for business, collateral includes some mixture of real property, cash accounts, unpaid invoices, inventory and/or equipment, and sometimes a personal guarantee from a co-signer.