Expert Speak
Ed Rogoff
Professor Management and Chair of the Management Department, Baruch College, City University of New York,
Author of Bankable Business Plans published by Rowhouse Books
Speaks about how banks decide on loans to entrepreneurs. What factors are critical to banks when it comes
to giving out loans to entrepreneurs? What are their parameters of evaluation. You may contact him at
edward.rogoff@gmail.com.
How Banks Decide on Loans
When most entrepreneurs think of obtaining the financing they need to build their businesses, they usually
think of banks as a likely source. But the reality can be otherwise even before the recent credit crisis.
Banks can be tough for entrepreneurs to deal with, but if you understand the bank's decision making process,
you will put yourself in the best possible position. From the bank's point of view, every time they make a
loan, they assume the risk that they may not be paid back.
Banks manage this gamble by several means: lending to low-risk people, whom they call “creditworthy,”
lending less than the customer is requesting, obtaining collateral or a guarantee from a third party whom
they judge to be creditworthy, charging higher interest rates and fees to compensate for accepting risk,
obtaining collateral that they can seize and sell if the loan is not paid back, and, most often, by not
lending at all. Banks judge their loan decisions by looking at such personal factors as:
- Your Credit History. In this electronic age, lending sources can instantly evaluate how quickly and
thoroughly you have paid your obligations to banks and other financial companies. Late payments, delinquent
loans, bankruptcies, how much credit you have been extended by banks, credit card companies, department
stores, and credit bureaus are all readily available to potential financial sources at the touch of a few
computer keys.
- Your Character.
Ultimately, the loan decision often comes down to a personal evaluation made by one or
more loan officers. I've witnessed loans granted to entrepreneurs with bankruptcies in their past and
loans denied to people with stellar credit histories because the loan officers' sixth sense was triggered.
This is so common that banks have a term for loans made to people without enough credit worthiness to
sustain a loan. They're called “character loans.”
- Your Collateral.
Nothing makes a banker happier than collateral to back up a loan. Mortgages are
collateralized by the houses they finance. Leases are collateralized by the equipment that is being
leased. Having collateral is a way for a bank to be repaid if the loan is forfeited. Most lending
sources require existing collateral such as an entrepreneur's home, securities, or other assets, before
they grant small business loans.
- Your Personal Guarantee. Lending sources want to make the entrepreneur generally liable for the loan,
not just the business she's starting. A personal guarantee provides this assurance without necessarily
specifying the particular collateral. If you have few assets, a personal guarantee may not mean much,
but if you have a home with significant equity value, or a large savings or investment account, giving the
bank a personal guarantee will make the officers very happy, just as it should make you very nervous.
- Government Loan Guarantees. Federal agencies, such as the Small Business Administration, and various
state programs help banks say yes to loans by essentially agreeing to guarantee repayment of some portion
of the loan, ranging between 50% to 90%. While these government loan guarantees carry a paperwork burden
for both entrepreneur and lender, they encourage lenders to feel more comfortable approving loans. The
presence of a government guarantee rarely stops a lender from asking for – and usually receiving – other
collateral or personal guarantees for the loan. This gives bankers more than 100% in collateral and
guarantees and is rather like wearing both a belt and suspenders – unnecessary and unattractive, but it
certainly keeps your pants up.
- Your Credit Scoring. Some credit research firms, most notably Fair, Isaac and Company, calculate
a single figure into what they call a credit score for entrepreneurs. Factors such as your payment
history, the amount of borrowing relative to your credit lines, recent inquiries by other financial
institutions, and the types of credit you use, are put into a computer model that produces this single
number, which is scored on a scale from a low of 400, representing poor credit, to a high of 900,
representing strong credit.
The best loan for any banker is one in which the business generates enough money to comfortably make the
interest payments and ultimately return the entire amount of the bank's money. Government guarantees,
personal guarantees, and collateral are just fall back positions in case the business fails and the
entrepreneur defaults on the loan. Collecting from a guarantee or taking and selling collateral generate
a huge amount of work and aggravation for the bank and invariably mark the end of its business relationship
with the borrower. When a business performs as anticipated, meets its obligations, and even grows to the
point that its credit needs increase, the bank, the loan officers, and the entrepreneur have a win-win
situation on which they can build a long-term, mutually beneficial business relationship.
This long term, mutually-beneficial business relationship must start with financial projections the
bankers find credible and then, throughout the relationship with the bank, prove to be credible. Of course,
you want to have a strong credit score, show yourself to be of good character, and be able to offer as much
in collateral or guarantees as are needed so the bank makes the loan, but, in the long run, financial
performance and credibility are what truly matter.