If you’ve taken the leap to create a small business out of your passion or bring a great idea to life, you might wonder whether taking a business loan is a good decision. On the one hand, the cash injection could be the spark to make your company a success, allowing you to purchase vital stock, equipment, and hire strong talent. On the other hand, it could constitute a risk for a newly-founded company, placing a strain on cash flow without a guarantee of financial success. In the worst-case scenario, could it also affect the personal credit of the directors?
Many directors in this position have asked this question. In this article, Clarke Bell will answer it, discussing how business debt can affect your personal credit, and ensure you have the information you need to make the best decision.
What is the difference between business credit and personal credit?
Before we discuss how business debt could impact your personal credit, let’s first look at how the two types of credit are distinct. Some differences are quite obvious, but others are less so. Firstly business credit refers to a company’s creditworthiness, just as personal credit does for individuals. This creditworthiness directly impacts the ability of the company to take out new loans, the terms of these loans, and how much a creditor might lend to a company. The higher the credit score, the less risky an investment a company is perceived to be, and the better its chances of getting a business loan. While this works quite like personal credit, there are certain differences. Companies can typically take out a far larger amount of credit than individuals, and business credit is firmly attached to the company in question. If it closes down, its credit score goes with it.
Personal credit works much the same as business credit; a credit score is obtained through keeping a strong credit history, a high score demonstrates good creditworthiness, and will increase your chances of a successful loan application with favourable rates. Although personal credit functions much the same as business credit, there are certain key differences. For example, unlike business credit, personal credit is tied directly to you. This means that it’s with you for the long haul, and cannot be written off the same way business debt can upon the closing of a company. In addition, individuals generally cannot expect to take out as much credit as companies, making a high personal credit score a very important priority.
How can business debt impact personal credit?
As personal credit is significant to an individual for reasons outlined earlier, it is important not to take unnecessary risks that could damage it. For this reason, knowing whether business debt could impact your personal credit is vital.
In general, taking on business debt will affect your personal credit, though exactly how will depend on your situation. Some scenarios will have a more significant effect than others, depending on certain factors. Before you take out a business loan, it’s a good idea to know where you stand and the implications of taking out a business loan for you.
Acting as a sole trader
If you have registered your business as a sole trader, as is the case for many upon opening a small business, business debt will have a strong effect on your personal credit. This is because there is no legal difference between you and your company; you are considered one and the same. Business debt, therefore, is essentially considered personal debt, and will affect your personal credit accordingly. Moreover, this debt is not directly tied to your company, meaning you will be responsible for repayments, whether your company succeeds or not. This is also true for companies classified as partnerships, where all partners are responsible for the entirety of the company’s debt.
Personal guarantees and business debt
If you signed a personal guarantee as part of a business loan agreement, then you are personally responsible for repaying this debt if your company cannot. Personal guarantees are often a part of loan agreements for limited companies, essentially meaning that the directors agree to waive this limited liability. Although the implications of personal guarantees aren’t felt immediately, they will influence the decision of creditors to approve a loan application, should the company require further credit. Moreover, if the company fails and the debt obligation is transferred to the personal guarantee’s signatory, it will function the same as personal debt. Late payments will damage their personal credit, making it more difficult to obtain loans in the future.
Using a business credit card
A business credit card is one way to take on business debt. While this might seem like it has no bearing on your personal credit, this is not the case. Upon making an application for a business credit card, the lender will usually look into your personal credit via a hard credit inquiry, also known as a hard pull. This inquiry will show a lender your personal credit file, including your personal credit score, loan history, and even how many hard credit inquiries have been made. With this information, a lender can gauge how much of a risk you might be.
Hard credit inquiries have certain implications. First, each inquiry will likely reduce your credit score, even if a lender deems you to be a low-risk borrower. Naturally, this can affect your chances of obtaining credit in the future. Secondly, it will have the reverse effect on your business credit score, building it up and making future loan applications that much easier. As with any kind of credit, it is very much a balance of risk and reward.
How to deal with business debt
If you have taken on business debt to help fund your company’s operations, but things haven’t gone according to plan, knowing how to deal with this debt will be very helpful indeed. Depending on your situation and preferred outcomes, you have a couple of options available.
Firstly, you could opt for a Creditors’ Voluntary Liquidation (CVL). This insolvency procedure is an excellent solution for companies without a viable path out of debt. It can be initiated voluntarily by a company’s directors, and allows them to appoint an insolvency practitioner of their choosing. This insolvency practitioner will then begin to wind up the company; they will identify company assets, dispose of them efficiently, and distribute the proceeds amongst creditors. The company will then be wound up and removed from the Companies House register. At this point, any remaining debt will be written off. For a more detailed look at Creditors’ Voluntary Liquidations, read our complete guide to the process.
If you would prefer to keep your company operating, but need the means to deal with business debt, a Company Voluntary Arrangement (CVA) might be the better option for you. This procedure allows companies that are struggling with debt, but have a viable path to recovery, to renegotiate their loan agreements with creditors. While this won’t decrease the overall amount payable, it can help create repayment terms that the company can afford, allowing it to continue into the future, and creditors to receive their repayment in full, albeit perhaps a bit later than they would like. As with a CVL, this procedure will be carried out by an insolvency practitioner of the directors’ choosing. They will negotiate with creditors on behalf of the company, ensuring a good resolution for all parties is reached.
Clarke Bell can help
If your company is struggling with its business debt, don’t go it alone; let Clarke Bell help. We have more than 28 years of experience in helping companies find the best solutions to their financial problems, and we can do the same for you. Don’t hesitate to contact us today for a free, no-obligation consultation and find out exactly what we can do for you.