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Business loan underwriting — understand how your application is evaluated
Exactly how do lenders decide you’re worthy? Here’s how to tip the process in your favor.
You know that loans come with eligibility requirements. But how do lenders actually decide whether you’re a worthy borrower? In short, lenders assess your application through a process called underwriting.
An underwriter’s job is to make sure that you aren’t too much of a risk for the lender to take on. They want to be absolutely sure that they can get their money back if all goes wrong and you default. Here’s what you should know to tip underwriting in your favor.
How does loan underwriting work?
After you’ve submitted your loan application, documents, sweat and tears — then what? You don’t have much else to do but wait, but the lender’s job is just beginning.
First, everything goes to an underwriter. An underwriter determines the risk of offering you a loan and then compares this risk against a lender’s parameters to decide whether it’s acceptable.
There was a time when lenders evaluated applications manually, but many lenders today automate the process with underwriting software and proprietary algorithms. Automated underwriting means that lenders can approve your application in a matter of minutes — rather than in weeks or months.
What factors do small business loan underwriters consider?
Underwriters take into account a lot of different criteria, depending on who you’re borrowing from and the type of loan you’re looking for.
- Your business’s monthly revenue. Lenders don’t want to lend you money if you’re unable to prove that your business brings in enough money to pay it back. Many require businesses to make at least $10,000 a month.
- Your personal credit score. To a lender, having good credit proves you have experience managing debt. Some online lenders don’t pay as much attention to credit scores as banks will, but solid creditworthiness never hurts.
- The value of your collateral. If you’re taking out a secured business loan, lenders want to make sure that your collateral is at least worth the amount you’re asking to borrow.
- Other sources of repayment. Underwriters will consider other ways you could repay your loans like personal or government guarantors and insurance.
- Personal equity. Did you help finance your small business when it was just starting up? Maybe you invested your own personal assets. Lenders like to see that you have something at stake when you’re applying for a loan.
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How do I explain financial gaps to a lender?
Automated and electronic approvals typically require your information to fit in specific fields and boxes, squeezing out the ability to explain financial gaps or clarify information.
If you’re worried about presenting a clear, complete picture of your past, consider going with a lender that uses manual underwriting. Keep in mind that a manual process can require more time than one that’s automated — and that your explanation might still not be enough.
Leverage your loan application with a business planRevenue, tax forms and other documentation might not tell your business’s whole story. If that’s the case, a business plan can make all the difference. This document is where you get to make a case for yourself when you’re borrowing from a lender that uses manual underwriting.
How to write a great business plan
Understanding underwriting ratios
Underwriting ratios are frequently the most important criteria lenders use when deciding whether to lend you money. The idea is to tell your lender that you have enough assets to pay back your loan if you default.
Four financial ratios to know:
- Debt service coverage ratio. This ratio compares your business’s income and assets with the total amount of funding it’s already borrowed. You might have trouble with approval if your DSCR is below 1.25.
- Debt-to-asset ratio. Underwriters often consider this if you’re applying for a loan without collateral. They want to make sure you have enough in assets — usually equipment or property — to cover the cost of the loan in the event that you default. Lenders typically look for a ratio of more than 1.0.
- Loan-to-value ratio. In this case, value refers to your collateral. Make sure that it’s worth at least the amount you’re taking out. It should be at 0.8 or lower — meaning that your collateral is worth at least 20% more than the amount you want to borrow.
- Ratio of net worth to loan size. Comparing your company’s or personal net worth — meaning financial assets and debt — to the loan amount is another way that underwriters make sure you can afford the loan. Something close to 1.0 is ideal, but some lenders might be more forgiving.
It’s important to consider your lender’s underwriting process when looking for a business loan. Loan underwriting differs by lender, but you’ll more often end up with a lender that uses automated underwriting software — especially if they promise a quick response.
If your application needs some ‘splaining, you might want to specifically look for a lender that uses manual underwriting to get the benefit of a human reviewing your initial application.
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