One of the first things you’ll likely consider when starting or expanding your business is how you’ll be able to operate profitably. Many small business owners plan to take out a small business loan for capital and pay off the debt with revenue. However, there’s no guarantee that you’ll qualify for the loan you want right away. It’s a good idea to understand qualification criteria and why your loan application may be rejected. Below are several common reasons you may be turned down for a loan and how you may be able to increase your likelihood of approval.
10 potential reasons for business loan denial
Traditional lenders are the most likely to reject a small business loan application. They often lend more money than other lenders, so they have more to lose if borrowers can’t repay the debt. That’s why they enact strict eligibility requirements to avoid defaults
That creates numerous potential reasons your application might be rejected, but knowing those reasons beforehand may help you become a more ideal borrower. Here are 10 common reasons for business loan rejection.
1. Excessive pre-existing debt
One of the first things a lender may look at to determine your eligibility is the amount of debt you already have. Running a business can be costly, so it’s expected that you’ll already have some debt. But the lender will also look at the ratio between how much you owe and how much money your business earns. If the difference between your business’s debts and revenue is too great, they’ll likely reject your application. In fact, according to the Federal Reserve, too much debt is the leading cause of loan rejection.
2. Bad credit score
You’ll be hard-pressed to find a lender that doesn’t check your personal credit score and business credit score to determine your eligibility. Both scores measure how reliably you’ve repaid your debts in the past, and that can help lenders decide whether they’ll see a return on investment. The minimum credit score required varies by lender, but generally stays within a specific range. Banks in the SmartBiz® network require a personal credit score of 640 or higher to qualify for an SBA loan.
Generally, you should aim for personal and business credit scores of at least 650. If your credit rating isn’t quite at that level, you can generally take action to increase it. Smart use of personal and business credit cards and lines of credit – as in, repaying each on time – can gradually boost your credit.
3. Unequal collateral
Collateral refers to any assets of sufficient value that the lender can sell to recoup their losses if you can’t repay the loan. If the value of your collateral isn’t near or equal to the value of the loan, the lender may reject your application.
Something else to consider is the type of collateral you offer. Depending on the type of loan you apply for, the lender can require anything from money, equipment, future revenue, or even your personal home or car. When you apply for a loan, make sure you understand the terms surrounding collateral and ensure that your assets are roughly equal in value.
4. Insufficient debt-to-income ratio
The amount of debt you owe as compared to how much money you bring in plays a key role in your eligibility for most financing options. Most lenders don’t want to provide money to borrowers who have already accrued a lot of debt and don’t have the inflows to repay additional loans. That isn’t to say they expect you to have no debt at all, lenders just want to be sure you can repay your loans with your current profits.
To determine if your business can handle another loan, lenders will calculate your Debt Service Coverage Ratio (DSCR). The DSCR is found by dividing a business’s annual Net Operating Income (NOI) by its annual debt payments. For example, let’s say your business’s NOI was around $180,000 while your annual debt payments were about $140,000. To find your DSCR, you would input both variables into the equation below:
Annual Net Operating Income / Business’s Annual Debt Payments = Debt Service Coverage Ratio (DSCR)
180,000/140,000 = 1.3
To add context to the final result, most lenders expect a minimum DSCR of at least one and they tend to look more favorably on ratios of 1.2 or higher.
5. Decreasing annual revenue
A lender wants to protect itself from financial risk, so it stands to reason that they’d only finance successful businesses. If your company’s profits are trending downwards, that can cast doubts on your ability to repay your loans long term. That could result in a rejection.
6. Unreliable industry
Lenders will have fewer incentives to give you money if your business is in a market with a high rate of failure. That isn’t to say it’s impossible, but your application will be held to a higher standard, making it more difficult to qualify. While switching to a more reliable industry may not be feasible, there are lenders out there who cater to more volatile industries.
7. Limited customer base
Lenders aren’t just interested in the amount of money you make versus what you owe. They have a vested interest in the stability of your profits, so they’ll likely take a close look at the customers you serve. Generally, financial institutions tend to favor applicants who cater to a large variety of customers.
If your business only caters to one type of client, what happens when outside events disrupt that demographic? Catering to a limited number of clients can promote loyalty to your business, but diversifying your customer base points to less financial risk overall.
8. Unfinished application
Applying for small business loans is often a long and complicated process that requires a lot of documentation. It’s not uncommon for business owners to spend upwards of 30 hours completing their applications.
So don’t be discouraged if your loan gets rejected due to missing information. It’s a common problem, and it might be the most straightforward one to fix – sometimes it might be as simple as adding what’s missing. Some of the most important documents required include a business plan, bank statements, tax returns (personal and business), and credit reports. Note that banks in the SmartBiz network do not require a business plan to apply for funding.
9. Limited or non-existent credit history
When a lender looks at your credit history, they’re trying to determine how responsible you’ve been with repaying debts in the past. If you lack an established credit history, then the lender has no way to verify your ability to repay the money you borrow. (Your credit history documents your lifetime credit usage, whereas your credit score is a brief numerical snapshot of your history.)
Starting a credit history for your new small business is generally relatively simple - just sign your business up for a credit card, use it regularly, and pay off the debt on time. Building it to the point of qualifying for a loan could take some time, but your card can help to get you started and provide some funds in the meantime.
10. Poor business performance
The success of your business is a huge factor in determining your eligibility for a loan. Lenders are hesitant to give money to companies with lackluster revenue because they’re not likely to be repaid. Less-than-stellar performance can lead to a loan application being rejected in some circumstances. In other scenarios, it may lead to a lower level of funding until you resolve those issues.
What can you do if your loan is denied?
Having a loan rejected may seem like hitting a brick wall. But if applying to a traditional lender doesn’t work, plenty of options are available to help you secure funding.
Look at a different loan type
If you’re not having much luck with traditional lenders, alternative lenders may be a better financing option for your business. Generally, alternative lending plans pay out less money while having fewer hoops to jump through to qualify. Additionally, alternative financing often has reduced processing time for applications, meaning you can get your money faster.
However, alternative lending does come with significant drawbacks. Alternative loan plans often come with shorter lending terms, extra fees, and higher interest rates that lead to larger monthly payments.
Find out the reason it was denied, then fix it
Just because a lender denied your application once doesn’t mean it will be rejected next time. There are numerous reasons why the lender may have denied your loan, so ask why. You may be able to get the funding you need as long as you reapply with the problems fixed.
Strengthen your application
Fixing your business's old issues is a good first step, but it’s also essential to give it new strengths to help it stand out. Think about it like this: You probably won’t be able to reapply right away after a bank denies your application. That period between applications is time you can use to improve your business where it may have been lacking before.
You could draft a more detailed business plan, improve your personal and business credit scores, and expand to new clientele. This way, you’re more likely to qualify next time.
Even if you know why your application failed the first time and have all the strategies to fix it, a loan rejection can still be disheartening. Gathering all the necessary documentation and filling out the application can be time-consuming. So, of course, having to do it more than once can be frustrating.
However, if your business is in good shape and you’ve addressed the issues above, consider working with SmartBiz. Our financial professionals can help guide you through our streamlined application process to help you secure an SBA loan, Bank Term loan, or custom financing.
*We conduct a soft credit pull that will not affect your credit score. However, in processing your loan application, the lenders with whom we work will request your full credit report from one or more consumer reporting agencies, which is considered a hard credit pull and happens after your application is in the funding process and matched with a lender who is likely to fund your loan.
WHAT YOU NEED TO KNOW: The SmartBiz® Small Business Blog and other related communications from SmartBiz Loans® are intended to provide general information on relevant topics for managing small businesses. Be aware that this is not a comprehensive analysis of the subject matter covered and is not intended to provide specific recommendations to you or your business with respect to the matters addressed. Please consult legal and financial processionals for further information.