Although SMEs (small and medium enterprises) have been growing at a healthy rate in India, they face problems like limited access to technology, skills, markets and capital. The stringent eligibility criteria imposed by banks and the requirement of collateral restrict SMEs from securing adequate and timely credit needed for business sustenance and growth. Desperate for liquidity, SMEs keep applying for loans to banks, unaware that this may impact their credit score.
All traditional banking institutions check an SME’s credit score to determine their creditworthiness, before extending a loan to them, what they call as hard credit inquiry. The bad personal credit score of the business owners or the main person(s) managing the business ruins the chances of an SME receiving an approval for the loan. Unfortunately, the reverse is also true. Whenever a new business applies for a loan, its credit score is impacted and significantly reduced. If the SME loan for new business is approved, status quo is maintained. However, if the loan application is rejected for any reason, the CIBIL score is lowered, which impacts the SME’s chances of qualifying for a business loan with the best rates in the future. Moreover, the traditional banking institutions rarely inform the SME that they are conducting a hard credit inquiry and enquire whether the SME wishes to go ahead with this.
Impact of a Hard Credit Inquiry on an SME’s CIBIL Score
The need for working capital drive SMEs to constantly apply for short-term loans or use their credit cards frequently. Little do these companies realize that these activities severely impact their credit scores, which ultimately lowers their chances of getting loans approved. Traditional banking institutions typically conduct a hard credit inquiry for approving an SME loan in India. In this inquiry, these financial institutions find out in-depth details of the SME’s complete credit history. Every hard inquiry can reduce the credit score by 1 to 5 points, where the exact number of points deducted depends on the type and size of loan the SME has applied for. The impact of the credit score usually wears off in about a year; however, the hard credit inquiries remain on the SME’s CIBIL report for around two years. This is visible to all other financial institutions that check the credit score during that period, severely affecting the SME’s loan eligibility.
On the other hand, if SME finance companies conduct what is known as a soft credit inquiry, the credit score of the business is not impacted. A soft credit inquiry is considered to be a more casual inquiry of the borrower’s creditworthiness.
What is a Soft Credit Check?
When a firm is looking for an SME loan and asks for a preliminary quote, most lenders would conduct a soft credit inquiry. This entails getting a summary of the SME’s credit report. SME finance companies would use this summary to determine whether or not the SME represents a risk or can be approved for the loan. The SME’s credit score will not be impacted by such an inquiry. In fact, it is not even visible or accessible to any other lender checking the SME’s creditworthiness. The impact on the credit score will show up only in the requested copy of CIBIL score by the business owner.
However, after being satisfied with the preliminary quote, in case the SME wishes to apply for the loan, the lender would conduct a hard credit inquiry before actually approving and sanctioning the loan. This process might impact the credit score of the business.
Keep Your Credit Score Intact When Applying for an SME Loan for New Business
There are two things that a business can do to keep its credit score intact even when applying for an SME loan:
Limit Loan Rate Shopping
Many financial institutions conduct a hard credit inquiry even to pre-qualify the business and give them a preliminary quote. Hence, the first precaution that an SME can take is to avoid loan shopping. It’s best to apply to only two or three lenders for an SME loan in India.
Opt for Unsecured Loans from FinTech Lenders
Over the past decade, FinTech companies have come up with a number of innovative and SME-friendly solutions. These SME finance companies rely on technology and alternate data for determining creditworthiness. They are not solely dependent on the borrower’s CIBIL score to determine the loan approval. Thus, applying for a loan to FinTech companies does not impact the credit score of the business.
The alternative credit scoring used by FinTech companies has been a game changer for SME loans in India. This system uses data from mobile phone records, social media scoring and assessment of the business owner’s networks, along with a plethora of other data points to determine creditworthiness. Driven by cutting-edge technology, FinTech companies are able to use these data points and approve loans within hours.
Thus, an SME applying for a new business loan should try to limit their loan shopping to a few lenders, when approaching traditional banking institutions. Else, the SME should approach FinTech companies for unsecured loans, such that their credit scores remain intact, even when applying for loans.