Do business loans affect personal credit?
The short answer is yes and no.
A business loan can affect your personal credit, but its impact depends on your business structure, type of financing, and your own credit history. Similar to how varied ingredients create distinct cakes, the variables above affect personal credit differently.
Let’s delve into specifics.
The difference between business and personal credit
Firstly, we need to distinguish between personal and business credit:
Personal credit refers to your personal financial history and creditworthiness based on past borrowing and repayment behavior. Lenders use it to determine your ability to manage debt.
Personal credit scores are also used by other businesses, such as insurance companies and utility companies, to make decisions about your eligibility for certain products and services.
Business credit refers to your company’s ability to pay back debts and manage finances. It evaluates your business’s financial stability and influences decisions related to partnerships and investments.
Besides credit unions and banks, suppliers and vendors may also use business credit scores to determine whether they can extend credit terms to your business.
Your personal credit score report remains with you for life, whereas your business credit report stays with the business. Although the latter reflects how you handle your business’s finances, if you were to sell it, that report follows the new owner.
The ways business loans affect personal credit
Where a business loan impacts your personal credit depends on two main factors:
1. Business structure
If you are a Sole Proprietor or Partnership, there is no legal distinction between yourself and the business. This means that any debts or liabilities of the business are also your personal responsibility.
However, if you choose to operate as a Limited Liability Company (LLC) or Corporation, your credit will generally remain unaffected unless you personally guarantee or co-sign a loan for your business.
2. Personal guarantees and co-signing
A personal guarantee is a loan where you guarantee to repay the money if your business cannot, meaning your lender can personally pursue assets such as your home and vehicle to recover the money owed.
While a co-signed loan can secure a lower interest rate, it carries risk for you, the co-signer, who becomes legally responsible for the business debt if your initial borrower defaults.
How defaulting on a business loan affects personal credit
Suppose you have co-signed or provided a personal guarantee to take out a business loan. Failing to pay it back may result in the following:
- Damaged credit score: Defaulting on a business loan will make it difficult to get future loans, as lenders will view you as a high-risk borrower.
- Legal action: Your lender can obtain a court order to seize your personal assets, such as your home, vehicle, or savings.
- Forced bankruptcy: You may be forced into declaring bankruptcy, damaging your financial health and business credibility.
Why you should separate personal and business credit
Do business loans show up on personal credit reports? They can.
Agreeing to a co-signed or personal guarantee for a business loan does not necessarily result in bankruptcy. Still, it may impact your credit score in less apparent ways related to hard and soft credit inquiries.
|Hard credit pull
|Soft credit pull
|A type of credit inquiry that occurs when your business applies for a loan, credit card, or financing
|A type of credit inquiry that occurs when your business checks its own credit report, or when a lender checks to pre-approve for a loan or credit card
|Impact on credit report
|Recorded on your business’s credit report
|Not recorded on your business’s credit report
|Impact on credit score
|Can lower your business’ credit score
|Doesn't impact your business’s credit score
Each hard inquiry noted on your credit report lowers your credit score by a few points. To lenders, multiple inquiries indicate a heavy reliance on credit or that you’re taking on too much debt.
An example of how hard inquiries can affect your personal credit score
Let’s say you’ve taken out a business loan linked to your personal credit. You’ve made large profits and want to purchase a house.
When you requests a mortgage, the lender will conduct a rigorous review of your credit report. This, in addition to the previous inquiry for the business loan, could lower your credit score.
The lender will also consider your debt-to-income (DTI) ratio, the percentage of your monthly income that goes toward debt and payments. Anything higher than 45% is considered a risk by most lenders.
Your business loan may factor into this ratio and make you appear as a high credit risk, prompting a higher mortgage interest rate or, in the worst-case scenario, mortgage denial.
The icing on the cake: balancing business needs and personal credit health
By following these steps, you can establish a clear separation between your personal and business credit:
- Register your business as an LLC or corporation.
- Open a business bank account to keep personal and business finances separate.
- Get a business credit card to establish business credit independent of your own.
Rather than offering your assets as collateral, you can explore alternative lending options such as business lines of credit (a revolving loan) and invoice financing (borrowing funds against outstanding invoices).
The importance of properly managing business and personal credit
Keeping your business and personal finances separate simplifies filing taxes, establishes good credit, and enables future growth and expansion possibilities (such as hiring employees or obtaining other business loans).
Moreover, it protects you from being personally responsible for any debts incurred by your business.
As you would for your personal credit, managing and improving your business credit score is essential to showcase your credibility, reliability, and value as a business owner.