Obtaining a Loan - The C's of Credit

Many small agricultural businesses are started using personal savings, funds from friends or family, or credit cards. While these are all options, you may wish to obtain a loan from a lending institution due to a need for a piece of equipment or moderate expansion. There are many options when considering who to approach for a loan.Creating a business plan will tell you how much funding will be required and how the repayment process will take place.

Personal Savings

When you consider using your personal savings to begin your business, be sure you are willing to place your savings at risk. Many businesses fail within the first five years and one of the main causes is under funding. Do not exhaust your entire savings because if you approach a commercial lender, they will want to see you have a vested interest in the business and your savings may satisfy that requirement. If you have already used the portion of your savings you are willing to invest, you may not have enough to meet the amount required from the lender. Lenders will not loan all of the funds needed, so having savings remaining will bridge the need between what you can borrow and what you need.

Borrowing from Friends or Family

Even if you are approaching friends or family, the loan should be written and signed by both parties. Prepare a written document that states the amount of funds borrowed, interest rate (if any), and the term of the loan. Having the written document will help eliminate any future conflicts. It does not need to be notarized or recorded at the courthouse, but it should be in writing. Provide them with a copy of your business plan.

You should also spell out what the funds will be used for and how you plan to cover the repayment of the loan and interest. Make sure all closely related family members of the person lending the funds know about the loan and terms. Many family relations have been strained for years because of not knowing about loans or gifts involving family members.

Credit Cards

We have all heard that you should not charge more to a credit card than you can repay in a month. However, many small start-up businesses are initially funded using credit cards. Your interest rates will be much higher than you might pay at a bank or from others but in some cases, a credit card may be your only option. Just keep in mind that it is a loan and you will need to pay it back. Also, large credit card balances may lower your credit score and impact future loan potential.

Borrowing from Commercial Lenders

When approaching a commercial lender, you will probably face more scrutiny than you would from borrowing from family members. The lender will not have as close of a relationship as your family member. Because of this, you will need to build a trusting relationship with the loan officer. You will want to demonstrate that you will be able to repay a loan. To start, they will probably ask for a business plan, a balance sheet, and the last two or three years of income tax returns. These documents will assist in building the relationship and trust, especially if you have not worked with the lender before.  These documents will also help the lender in their decision-making process.

Most commercial lenders will want monthly payments but if you cannot make monthly payments during the start-up phase of the business, you will need to demonstrate when you will have sufficient funds to do so in the future. Also keep in mind that the person you are working with may not be the person making the final decision on the loan. You need to be sure your lender has the necessary information to be able to recommend the loan.

Lenders will use the term "The C's of Credit." There are at least five C's of credit:

• Character or Credit History
• Capacity
• Capital
• Collateral
• Conditions
• And possibly Confidence

Character or Credit History
When meeting with your lender, be professional and courteous, you are approaching them for funding so keep this in mind. The days of lenders knowing your entire family and their history are over. In the past, lenders may have known your family for several generations, so they knew of your or your family's character, this is not usually the case today. They will need to get to know you in a short period of time and will make the recommendation to the loan committee or supervisor above them. This is highly subjective so your first impression will be critical.

If you are approaching a commercial lender, the first thing you should do is obtain a copy of your credit report and credit score. Many credit card companies are now offering this service for free or a very low fee. The credit report will show if you make your payments on time and will indicate the potential risk of lending money to you. The lender will be able to determine if you have any prior problems so make sure your report is as accurate as possible. Commercial lenders put great weight on your credit score, and they will always check your score. This is probably the most important C.

Capacity
How will you pay back the funds? Will you have enough potential income to pay the interest and principal of the loan? If you have a business plan, this will be outlined in the plan and the supporting documents. A business plan will also impress the loan officer in that, you have taken the time to create the plan and have developed several scenarios that will support your findings that you have the capacity to make payments.

Your employment history is another indicator of capacity used by lenders. Do you change jobs frequently or have you worked for the same person or company for many years? A steady source of income indicates that there will be outside income to help with the loan repayment. The lender will decide if additional debt will put any undue strain or your ability to repay new and existing loans while covering your living expenses.   

Collateral
Collateral is an asset that a lender accepts as security for a loan. Collateral acts as a form of protection for the lender in case the borrower cannot make the loan payments. If this happens, the lender can seize the collateral and sell it to recoup some or all its losses. Lenders do not want to have to seize and sell equipment or property to cover borrowed funds. Many small agricultural businesses begin as sole proprietorships. This means you are the business and the business is you.  Anything you own, or partially own, may be used as collateral for the funds you are requesting. If you want one of your personal assets protected, do not list it as collateral. This may be easier said than done as the lender will want to be sure their funds are protected.

A lender will want at least 100% of the loan covered by a form of collateral. If you are using borrowed funds to purchase a tractor, the tractor may serve as the collateral, but the lender may not cover the entire purchase price. You may need to pay 15-20% of the purchase price for the lender to use the item as collateral. If a loan is not a good option for you, consider leasing equipment instead. For more information on owning and leasing equipment, please see Managing Machinery and Equipment. Making lease payments on time will help improve your credit score. Whether using a loan or lease, you will need to insure the item used as collateral.

Conditions
The conditions consider the general, regional, local, economies as well as the economic health of the industry you are in or proposing. If you have been in business and the funds will be used for expansion in a thriving industry, the conditions the lender will impose will be more favorable to you. You may pay a lower interest rate and may be able to defer principal payments until you begin receiving the additional income.

If you are just beginning in an industry that is somewhat new and carries more risk, the conditions required by the lender will favor the lender. You may pay a higher interest rate and may be required to make monthly payments starting at the beginning of the loan. The lender may require a higher percentage of the total cost come from your personal funds. If you are considering this type of industry, make sure your business plan shows you can repay the loan in a risky environment. The lender may also require you to purchase crop insurance and name the lender as a payee.

Capital
This is the level of investment you are willing to make in the business. As previously stated, you will not be able to obtain a loan for 100% of the needed investment. If you have been in business for several years, you should have developed some owner's equity (the amount of the business you own). If you are just beginning the business, borrowing all the required start-up funds will be very difficult. You may need to combine several funding sources to achieve your goal.

Many larger agricultural loans today are a combination of funding from more than one source. A bank or Farm Credit cooperative may make a loan and the Farm Service Agency may offer a guarantee of the loan for a small increase in the interest rate. For more information on financing, please see Financing Small-scale and Part-time Farms.

Confidence
You will need to demonstrate confidence to the loan office you work with. Answer all questions to the best of your ability and be honest. The loan officer's confidence in your answers and supporting documentation will go a long way in receiving the funding you need. If the loan officer is able to approve smaller loans (around $50,000), their impression of you may determine your success.  

There are several programs that cater to (broadly defined) new and beginning producers. The Farm Credit system, the Farm Service Agency (FSA), both have programs specifically for new and beginning farmers. Check with your local offices for more details about these programs.

Almost every business will need to borrow funds at some point. You are not alone in needing additional funding to achieve the goals you have set. Follow the above recommendations and you should be successful if you can satisfy the C's of credit.