What is Credit Scoring?

http://www.business.gov/phases/launching/finance_startup/credit_scoring.html

Credit Scoring

Ever wonder how a creditor decides whether to grant you credit? For years, creditors have been using credit scoring systems to determine if you'd be a good risk for credit cards and auto loans. More recently, credit scoring has been used to help evaluate your ability to repay home mortgage loans. Here's how credit scoring works in helping decide who gets credit and why.

What is credit scoring?

Credit scoring is a system used to help determine whether to give you credit. Information about you and your credit experiences, such as your bill-paying history, the number, type, and age of your accounts, late payments, collection actions, and outstanding debt is collected from your credit application and your credit report. Using a statistical program, creditors compare this information to the performance of consumers with similar profiles. A credit scoring system awards points for each factor that helps predict who is most likely to repay a debt. The total number of points - a credit score - helps predict how worthy you are; that is, how likely it is that you will repay a loan and make the payments when due.

As your credit report is an important part of many credit scoring systems, it is very important to make sure it's accurate before you submit a credit application. To get copies of your report, contact the three major credit reporting agencies:

Equifax
P.O. Box 740241
Atlanta, GA 30374-0241
(800) 685-1111

Experian
P.O. Box 2104
Allen, TX 75013
(888) EXPERIAN (888-397-3742)

Trans Union
P.O. Box 1000
Chester, PA 19022
(800) 916-8800

These agencies may charge you up to $9.00 for your credit report

Why is credit scoring used?

Credit scoring is based on real data and statistics, so it usually is more reliable than subjective or judgmental methods, as it treats all applicants objectively. Judgmental methods typically rely on criteria that are not systematically tested and can vary when applied by different individuals.

How is a credit scoring model developed?

To develop a model, a creditor selects a random sample of its customers, or a sample of similar customers if their sample is not large enough, and analyzes it statistically to identify characteristics that relate to creditworthiness. Each of these factors is then assigned a weight based on how strong a predictor it is of who would be a good credit risk. Each creditor may use its own credit scoring model, different scoring models for different types of credit, or a generic model developed by a credit scoring company. Under the Equal Credit Opportunity Act, a credit scoring system may not use certain characteristics like race, sex, marital status, national origin, or religion as factors. Creditors are allowed to use age in properly designed scoring systems, but any system that includes age must give equal treatment to elderly applicants.

What can I do to improve my score?

Credit scoring models are complex and often vary among creditors and different types of credit. If one factor changes, your score may change - but improvement generally depends on how that factor relates to other factors considered by the model. Only the creditor can explain what might improve your score under the particular model used to evaluate your application. Nevertheless, scoring models generally evaluate the following types of information in your credit report:

Have you paid your bills on time? Payment history is typically a significant factor. It is likely that your score will be affected negatively if you have paid bills late, had an account referred to collections, or declared bankruptcy.

What is your outstanding debt? Many scoring models evaluate the amount of debt you have compared to your credit limits. If the amount you owe is close to your credit limit, it is likely to have a negative effect on your score.

How long is your credit history? Generally, models consider the length of your credit track record. An insufficient credit history may have an effect on your score, but that can be offset by other factors, such as timely payments and low balances.

Have you applied for new credit recently? Many scoring models consider whether you have applied for credit recently by looking at inquiries on your credit report when you apply. If you have applied for too many new accounts recently, that may negatively affect your score. However, not all inquiries are used; inquiries by creditors who are monitoring your account or looking at credit reports to make prescreened credit offers are not counted.

How many and what types of credit accounts do you have? Although it is generally good to have established credit accounts, too many credit card accounts may have a negative effect on your score. In addition, many models consider the type of credit accounts you have. For example, under some scoring models, loans from finance companies may negatively affect your score .

Scoring models may be based on more than just information in your credit report; the model may consider information from your application as well. These could include: your job or occupation, length of employment, or whether you own a home. To improve your credit score under most models, concentrate on paying bills on time, paying down outstanding balances, and not taking on new debt. It's likely to take some time to improve your score significantly.

How reliable is the credit scoring system?

Credit scoring systems enable creditors to evaluate millions of applicants consistently and impartially on many different characteristics, but to be statistically valid, credit scoring systems must be based on a sufficient sample. Remember that these systems generally vary from creditor to creditor. Although you may think such a system is arbitrary or impersonal, it can help make decisions more quickly, accurately, and impartially than individuals when it is properly designed. Many creditors also design their systems so that in marginal cases, applicants whose scores are not high enough to pass easily or low enough to fail absolutely are referred to a credit manager who decides whether the company or lender will extend credit. This may allow for discussion and negotiation between the credit manager and the consumer.

What happens if you are denied credit or don't get the terms you want?

If you are denied credit, the Equal Credit Opportunity Act requires that the creditor give you a notice that tells you the specific reasons your application was rejected, or the fact that you have the right to learn the reasons if you ask within 60 days. Indefinite and vague reasons for denial are illegal, so ask the creditor to be specific. Acceptable reasons include: "Your income was low" or "You haven't been employed long enough." Unacceptable reasons include: "You didn't meet our minimum standards" or "You didn't receive enough points on our credit scoring system." If a creditor says you are denied credit because you are too near your credit limits on your charge cards or you have too many credit card accounts, you may want to reapply after paying down your balances or closing some accounts. Credit scoring systems consider updated information and change over time.

Sometimes you can be denied credit because of information from a credit report. If so, the Fair Credit Reporting Act requires the creditor to give you the name, address, and phone number of the Credit Reporting Agency that supplied the information. You should contact that agency to find out what your report said. This information is free if you request it within 60 days of being denied credit. The CRA can tell you what's in your report, but only the creditor can tell you why your application was rejected. If you've been denied credit or didn't get the rate or terms you requested, ask the creditor if a credit scoring system was used. If so, ask what characteristics or factors were used in that system, and the best ways to improve your application. If you receive credit, ask the creditor whether you are getting the best rate and terms available and, if not, why. If you are not offered the best rate available because of inaccuracies in your credit report, be sure to dispute the inaccuracies in the report.

The Benefits Of Making Your Banker Your Friend

Cultivating a friendly relationship with your banker will benefit your business in many ways. http://www.business.gov/phases/launching/finance_startup/banker_friend.html. While every business has a bank, few have a banker. That's because bankers are too often seen as obstacles standing between an entrepreneur and the bank's vault. "You don't do business with an institution. You do business with people. When you get a banker who believes in you, you can accomplish incredible things," counsels Debbi Fields, founder and chair of the board of Mrs. Fields Cookies. The banker is the loan officer or office manager who handles your account. A good relationship with that person can bring you money in the form of credit, save you money in fees, and enhance your business opportunities through taking advantage of the banker's extensive personal contacts.

Relations between bankers and business owners take on as many hues and shapes as relationships between husbands and wives, but the best ones all have trust and honest communication in common. "Ideally, it's a human relationship as well as a business relationship," says Bill Byrne, an entrepreneur and author of Habits of Wealth.

Why Have A Relationship?

Better access to credit is one of many benefits garnered by those with good banker relations. The biggest intangible in any loan request is the person who is asking for the money, notes Mitch Hurly, vice president and manager at First Security Bank of Utah. The more secure a banker feels about a borrower's integrity, the better the chances for loan approval. A strong, trusting relationship helps give a banker the important sense of security. As credit is more than just loans, good banker relationships can also result in performance bonds, letters of credit, and the granting of credit lines, say several business owners. Tom Rose, co-owner of Marietta Industrial Enterprises Inc., a warehousing and transportation company in Marietta, Ohio, estimates he shaves 30 to 60 days off transactions such as getting loans or credit line extensions because of the close relationship established with his banker. When a deal's window of opportunity is narrow, a quick bank approval can make the difference between getting the deal and losing it. Bankers can also provide introductions to potential customers, suppliers, employees, and investors because of their many connections in the community. Only a strong relationship with the business owner earns such personal introductions. "If bankers say nice things about us, it's a tremendous reference," emphasizes Sidney Green, president and chief executive officer of Terra Tek, an environmental services firm in Salt Lake City. He's worked with the same bank since 1970, and his employees have benefited as well when they needed services such as auto loans and home mortgages. "My banker provides me with a lot of support and insights. I have a much higher comfort level, and that's worth a great deal to me," says Suzanne Edgar, president of Columbus, Ohio-based Epro Inc., a floor tile manufacturer, citing an important advantage of the relationship - peace of mind. Paul Sharfin, president of M&P Construction Company Inc., in Blacklick, Ohio, notes: "A banker is similar to your barber. You keep going to the same barber because you're comfortable with him; he takes care of you and he does a little bit extra."

Poor Relations Are Common

If banker relationships can be so beneficial, why do so many business owners suffer through poor ones or cultivate none at all? Often, the problem is that entrepreneurs don't understand the restraints and needs of bankers. Think of capital as a food chain, suggests Raymond Smilor, vice president of the Center for Entrepreneurial Leadership, Kauffman Foundation, in Kansas City, Missouri. Early in the food chain, capital should come from private investors such as family and friends. Later, professional investors such as venture capitalists can be tapped. Only when the business has solid assets and a steady track record is it ready for a banker. Smilor says that owners of emerging businesses often struggle with their bankers because they ask for too much given the immaturity of their companies.

Bankers, by law and temperament, are not investors. Risk and reward typically have a direct relationship - the higher the risk, the higher the reward. Investors decide to put money into an enterprise without guarantees they will get their money back, let alone a return, because the rewards can be large if the business succeeds . However, lenders such as banks don't have the same lucrative potential. Even if the money lent is the catalyst for putting a firm hold on the fast track to success, the most the banker can expect to get back is the capital (plus interest) in timely payments. That is one reason why bankers and entrepreneurs so often clash. The entrepreneur asks the banker to take an investors risk, while the banker's position is that he can only take credit risk because of the limited potential payoff. Until the banker and entrepreneur speak on the same wavelength and understand each other's vantage point, a good relationship can't exist.

Communication - or lack thereof - is probably the greatest area of weakness between entrepreneurs and bankers. When the news is bad, owners tend to shut down lines of communication, thinking the banker will be upset. While the banker may understandably be concerned, his/her reaction will be far less negative than if he/she is not told what is going on. Nothing upsets a banker more than surprises. Not all weaknesses rest with the business owner, however. Bankers change jobs more frequently than politicians stereotypically change their minds, so many may be unfamiliar with their customers and wary of extending credit even when the company is deserving. Relationships, whether personal or business, are always challenging. There are certain things an entrepreneur can do, however, to help create a climate that is conducive to fostering a productive, long-lasting relationship with a banker.

Creating a Good Relationship

Clear, frequent, open lines of communication are a necessary component of a strong owner-banker relationship. Owners and bankers should communicate at least quarterly, urges Dave Brown, senior vice president at Key Bank in Utah; he speaks to some clients every week. Bankers usually require quarterly financials with a major review once a year. If a loan is based on inventory or accounts receivable, monthly financials may be needed. There is more involved in communication than mailing out financials, however. Invite your banker to tour your facilities, recommends Scott Clark, author of Unleashing the Hidden Power of Your Growing Business. And, he warns, don't extend the invitation just before you ask for a loan, as that will arouse suspicion. Be sure to call your banker when something important occurs, such as gaining a major account or a major competitor. Put your comments down in writing to provide ammunition in case the banker's boss questions why something happened. It's also valuable in the event your banker moves on, as the replacement can quickly become familiar with your situation if your file is complete and up-to-date.

Identical to any relationship based on trust, this one requires time. Paul D. Brawner likens it to a winning football team that relies on its running game. "A relationship is like three yards and a cloud of dust," he says about the strategy that slowly but eventually results in a touchdown. "A banking relationship needs to be nurtured day in and day out, not once a year." Brawner is senior vice president of Huntington National Bank in Columbus, Ohio, and former chair of the American Banker's Association Small Business Unit. The adage "it's better to give than to receive" is true with a banking relationship. Don't ask for favors at the beginning. First give the bank your business and even try to bring in other accounts, which will create good will you can capitalize on later.

Don't Tell Them Everything

The banker can be a friend, ally, and consultant, but not someone in whom you necessarily confide, specifically about things that don't directly affect the banker's interests. If your marriage goes on the rocks, for example, don't rush to tell your banker. If something bad happens in your business, try to determine the cause and develop a plan for remedying the situation before talking to your banker. No business or business owner is perfect, so it's unrealistic for a banker to want to know everything that is happening. "We all have acne in a corporate sense. The banker doesn't need to be our business confessor," Bill Byrne notes. Pivotal to establishing a good banking relationship is finding the right banker. First, look at a bank's financials. A troubled or insolvent bank isn't going to do you much good, no matter how carefully you nurture a relationship with one of its bankers. Deal with officers as high up in the organization as possible, since upper management tends not to change jobs as frequently as lower-level employees. Many small and medium-sized banks cater specifically to small businesses, while some larger institutions have small business divisions. These banks tend to have bankers who are tuned into small business issues - exactly the type of banker you want. Just as you wouldn't hire the first applicant you interview for a secretarial position, why select the first banker you speak to? Interview several. Elizabeth Bradshaw, president of Ginny's Printing and Copying in Austin, Texas, says her favorite banker has "a great bedside manner." The emotional component in a relationship makes it important to find a banker with whom you are comfortable. When you have established and nurtured a good relationship with a banker, you can count on a brighter future for your business.

What a Banker Wants To Know

To maintain a good relationship with a banker, you must demonstrate professionalism and competence, says Henry W. Gardner, vice president at Bank One in Salt Lake City, Utah. According to Gardner, when a business owner asks for a loan, this is what a banker wants to know:

How much money do you want to borrow?
Why do you want the money, and how will it be used?
What is the primary source that will generate the funds to repay the loan, such as selling a building, selling inventory, or increased business?
What is the secondary source of repayment, such as liquidation of equipment or injection of additional capital by the firm's principal?
How will the loan be secured (collateral)?
Who will guarantee the loan? (The owner should be taking more risk than the banker.)

The 3 Ts of a Good Banking Relationship

Nearly everyone looking for a loan learns the five Cs of credit, which are: character (how trustworthy you are), capacity (your financial strength), capital (the amount of your own money invested in the business), collateral (assets available to back up the loan), and conditions (the state of the economy and your industry). Mitch Hurley, vice president and manager at First Security Bank of Utah, says that in addition to the five Cs, banking relationships are built on the three Ts:

Talk: For a relationship to thrive, the business owner needs to talk - communicate - regularly with the banker.The talk must be frank and open, even when reporting a negative development.

Time: A relationship takes time to grow. Don't rush it, and don't expect it to bear fruit immediately. Like friendships, a good banker relationship will age well over the course of its duration.

Trust: With honest, frequent communication and time, trust develops, which is "the foundation of the relationship," emphasizes Hurley. When trust exists on both sides, the relationship has the crucial component to make it a lasting one.

Borrowing Money

Know the essentials in borrowing money. Can your business afford it? http://www.business.gov/phases/launching/finance_startup/borrowing_money.html. Borrowing money is one of the most common sources of funding for a small business, but obtaining a loan isn't always easy. Before you approach your banker for a loan, it is a good idea to understand as much as you can about the factors the bank will evaluate when they consider your loan. This discussion outlines some of the key factors a bank uses to analyze a potential borrower. Also included is a self-assessment checklist at the end of this section for you to complete.

Key Points to Consider

Let's begin by exploring some of the key points your banker will review:

1. Ability/Capacity to Repay

The ability to repay must be justified in your loan package. Banks want to see two sources of repayment - cash flow from the business, plus a secondary source such as collateral. In order to analyze the cash flow of the business, the lender will review the business past financial statements. Generally, banks feel most comfortable dealing with a business that has been in existence for a number of years, as they have a financial track record. If the business has consistently made a profit and that profit can cover the payment of additional debt, then it is likely the loan will be approved. If, however, the business has been operating marginally and now has a new opportunity to grow, or if that business is a startup, then it is necessary to prepare a thorough loan package with a detailed explanation addressing how the business will be able to repay the loan.

2. Credit History

One of the first things a bank will determine when a person/business requests a loan is whether their personal and business credit is good. Therefore, before you go to the bank or even start the process of preparing a loan request, make sure your credit is good. First, get your personal credit report. You can obtain a report by calling TransUnion, Equifax, TRW, or another credit bureau. It is important that you initiate this step well in advance of seeking a loan; personal credit reports may contain errors or be out of date. In many cases, people find that they have paid off a bill, but it has not been recorded on their credit report. It can take 3 to 4 weeks for this error to be corrected, and it is up to you to see that this happens. You want to make sure that when the bank pulls your credit report, all errors have been corrected and your history is current. Once you obtain your credit report, how do you know what it says? Many people receive their credit reports, yet have no idea what the strange numbers signify. The following should help in interpreting and checking your personal credit report. First, check your name, social security number, and address at the top of the page. Make sure these are correct. There are people who have found that they have credit information from another person because of mistakes in their identification information.

On the rest of your credit report, you will see a list of all the credit you have obtained in the past - credit cards, mortgages, student loans, etc. Each credit will be listed individually with information on how you paid that credit. Any credit which you have had a problem paying will be listed towards the top of the list; these are the credits that may affect your ability to obtain a loan. If you have been late by a month on an occasional payment, this probably will not adversely affect your credit. However, if you are continuously late in paying your credit, have a credit that was never paid and charged off, have a judgment against you, or have declared bankruptcy in the last 7 years, it is likely that you will have difficulty in obtaining a loan. In some cases, a person has had a period of bad credit based on a divorce, medical crisis, or other significant event. If you can show that your credit was good before and after this event and that you have tried to pay back those debts incurred in the period of bad credit, you should be able to obtain a loan. It is best if you write an explanation of your credit problems and how you have rectified them; attach this to your credit report. Each credit bureau has a slightly different way of presenting your credit information. You can get specific information on how to read the report from the appropriate company, but here are a few tips to get you started:

In the last few years, TRW has prepared credit reports with words, not numbers. Good credits should read "Never Late," and "Paid as Agreed."

TransUnion, on the right side of the page are number and letter combinations. "I" means installment credit; "R" means revolving credit. The key information is in the numbers; a "1" means perfect credit - you have always paid your bills on time. "2" or "3" means you have been 2 to 3 months late in paying your bills. Too many of these will hurt your chances in obtaining credit. A "9" means delinquency in paying your bills and a charge off. This could make it difficult in obtaining a loan.

If you need assistance in interpreting or evaluating your credit report, ask your accountant or a friendly banker. If your credit report has a few problems on it, you may find that another bank may evaluate your report differently.

3. Equity

Financial institutions want to see a certain amount of equity in a business. Equity can be built up through retained earnings or the injection of cash from either the owner or investors. Most banks want to see that the total liabilities or debt of a business is not more than 4 times the amount of equity. (Or, stated differently, when you divide total liabilities by equity, your answer should not be more than 4.) Therefore, if you want a loan, you must ensure that there is enough equity in the company to leverage that loan. Don't be misled into thinking that startup businesses can obtain 100% financing through conventional or special loan programs. A business owner usually must put some of his/her own money into it. The amount an individual must put into the business in order to obtain a loan is dependent on the type of loan, purpose, and terms. For example, most banks want the owner to put in at least 20 - 40% of the total request.

Example: A new business needs a $100,000 to start. The business owner must put $20,000 of his/her own money into the new business as equity. His/Her loan will be $80,000. The debt to equity ratio is 4:1. Note that this is only one of many factors used to evaluate the business - simply having the right debt to equity ratio does not guarantee you'll get the loan.

The balance sheet indicates the amount of equity or net worth of a business. The net worth of the business is often a combination of retained earnings and the owner's equity. In many cases, an owner's equity will be shown as a loan from shareholders, and is therefore a liability. If a business owner wishes to obtain a loan, he/she will be obligated to pay the bank back first, not his/herself. Consequently, it may be necessary to restructure the liability so that it becomes the owner's equity, or subordinate the loan. If the current debt to net worth is 4 or over, it is unlikely that the business will be able to obtain additional debt/loan.

4. Collateral

Financial institutions are looking for a second source of repayment, which is often collateral. Collateral are those personal and business assets that can be sold to pay back the loan. Every loan program, even many microloan programs, requires at least some collateral to secure a loan. If a potential borrower has no collateral, he/she will need a co-signer that has collateral to pledge. Otherwise, it may be difficult to obtain a loan. The value of collateral is not based on market value; that is discounted to take into account the value that would be lost if the assets had to be liquidated.

5. Experience

A client who wants to open a business and has no experience in that business should not seek financing, let alone start the business unless they intend to hire people who know the business or take on a partner that has the appropriate experience. Regardless, the client should be advised to take some time to work in the business first and take some entrepreneurial training classes.

Questions Your Banker Will Ask

The key questions the banker will be seeking to answer are as follows:

Can the business repay the loan? (Is cash flow greater than debt service?)
Can you repay the loan if the business fails? (Is collateral sufficient to repay the loan?)
Does the business collect its bills?
Does the business control its inventory?
Does the business pay its bills?
Are the officers committed to the business?
Does the business have a profitable operating history?
Does the business match its sources and uses of funds?
Are sales growing?
Does the business control expenses?
Are profits increasing as a percentage of sales?
Is there any discretionary cash flow?
What is the future of the industry?
Who is your competition and what are their strengths and weaknesses ?

Credit Factors

The basic elements examined in every loan application. http://www.business.gov/phases/launching/finance_startup/credit_factors.html

Credit Factors a Borrower Should Know

To determine if you qualify for the SBA's financial assistance, you should first understand some basic credit factors that apply to all loan requests. Every application needs positive credit merits to be approved. These are the same credit factors a lender will review and analyze before deciding whether to internally approve your loan application, seek a guarantee from the SBA to support their loan to you, or decline your application altogether.

1. Equity Investment

Business loan applicants must have a reasonable amount of funds invested in their business. This ensures that, when combined with borrowed funds, the business can operate on a sound basis. There will be a careful examination of the debt to worth ratio of the applicant to understand how much money the lender is being asked to lend (debt) in relation to how much the owner(s) have invested (worth). Owners invest either assets that are applicable to the operation of the business and/or cash, which can be used to acquire such assets. The value of invested assets should be substantiated by invoices or appraisals for startup businesses or current financial statements for existing businesses. Strong equity with a manageable debt level provides financial resiliency to help create firm weather periods in operational adversity. Minimal or non-existent equities make businesses susceptible to miscalculation and thereby increase the risk of default - failing to repay - borrowed funds. Strong equity ensures the owner(s) remains committed to the business. Sufficient equity is particularly important for new businesses; weak equity makes a lender more hesitant to provide any financial assistance. Low (not non-existent) equity, however, in relation to existing and projected debt - the loan - can be overcome with a strong showing in all the other credit factors. Determining whether a company's level of debt is appropriate in relation to its equity requires analysis of the company's expected earnings and the viability and variability of these earnings. The stronger the support for projected profits, the greater the likelihood the loan will be approved. Applications with high debt, low equity, or unsupported projections are prime candidates for denial.

2. Earnings Requirements

Financial obligations are paid with cash, not profits. When cash outflow exceeds cash inflow for an extended period of time, a business cannot continue to operate. As a result, cash management is extremely important. In order to adequately support a company's operation, cash must be at the right place, at the right time, and in the right amount. A company must be able to meet all its debt payments, not just its loan payments, as they come due. Applicants are generally required to provide a report on when their income will become cash and when their expenses must be paid. This report is usually in the form of a cash flow projection, broken down on a monthly basis and covering the first annual period after the loan is received.

When the projections are for either a new business or an existing business with a significant (20% plus) difference in performance, the applicant should write down all assumptions which went into the estimations of both revenue and expenses; provide these assumptions as part of the application. All SBA loans must be able to reasonably demonstrate the ability to repay the intended obligation from the business operation. For an existing business which wants to buy a building where the mortgage payment will not exceed historical rent, the process is relatively easy. In this case, the funds used to pay the rent can now be used to pay the mortgage. However, for a new or expanding business with anticipated revenues and expenses exceeding past performance, the necessity for the lender to understand all the assumptions on how these revenues will be generated is paramount to loan approval.

3. Working Capital

Working capital is defined as the excess of current assets over current liabilities. Of all assets, current assets are the most liquid and most easily convertible to cash. Current liabilities are obligations due within one year. Working capital therefore measures what is available to pay a company's current debts. It also represents the cushion or margin of protection a company can give their short-term creditors. Working capital is essential for a company to meet its continuous operational needs. Its adequacy influences the firm's ability to meet its trade and short-term debt obligations as well as remain financially viable.

4. Collateral

To the extent that worthwhile assets are available, adequate collateral is required as security on all SBA loans. However, the SBA will generally not decline a loan where inadequacy of collateral is the only unfavorable factor. Collateral can consist of assets which are both usable in business and personal assets which remain outside business. Borrowers can assume that all assets financed with borrowed funds will collateralize the loan. Depending upon how much equity was contributed towards the acquisition of these assets, the lender is also likely to require other business assets as collateral. For all SBA loans, personal guarantees are required of every owner of 20% or greater, plus other individuals who hold key management positions. Whether or not a guarantee will be secured by personal assets is based on the value of assets already pledged and the value of those assets personally owned compared to the amount borrowed. In the event real estate is used as collateral, borrowers should be aware that banks and other regulated lenders are now required by law to obtain third-party valuation on real estate-related transactions of $50,000 or more. Certified appraisals are required for loans of $100,000 or more. The SBA may require professional appraisals of business and personal assets, plus any necessary survey and/or feasibility study.

Owner-occupied residences generally become collateral when:

The lender requires the residence as collateral,
The equity in the residence is substantial and other credit factors are weak,
Such collateral is necessary to assure that the principal(s) remain committed to the success of the venture for which the loan is being made, or
The applicant operates the business out of the residence or other buildings located on the same parcel of land.

5. Resource Management

The ability of individuals to manage the resources of their business, sometimes referred to as "character," is a prime consideration when determining whether or not a loan will be made. Managerial capacity is an important factor, involving education, experience, and motivation. A proven, positive ability to manage resources is also a large consideration. Mathematical calculations on the historical and projected financial statements form ratios which provide insight into how resources have been managed in the past. It is important to understand that no single ratio provides all this insight, but the use of several ratios in conjunction with one another can provide an overall picture of management performance. Some key ratios all lenders review are: debt to worth, working capital, the rate from which income is received after it is earned, the rate from which debt is paid after becoming due, and the rate from which the service or product moves from the business to the customer.

Source: http://www.business.gov/topics/finances/