6 Ways Being Self-Employed Can Impact Your Credit (& What to Do About It)
It’s ironic that in a country that celebrates independence and the entrepreneurial spirit, life can be pretty hard when you’re self-employed. Taxes are more complicated. Health insurance is expensive and difficult to navigate. Even at-work injuries and gaps in income usually covered by government programs are out of reach.
Credit is one of the farthest-reaching categories. Lenders prefer W-2 income to self-employed earnings, even when an entrepreneur is making more each month. Here are six specific ways being self-employed can create roadblocks for your financial goals, with insights on how you can overcome those roadblocks.
1. It Can Be Difficult to Get a Low Interest Rate
You might be approved for a loan, maybe even with no more hassle than somebody with a regular job. The trouble is when you look at your statement and see how much that loan costs.
Your credit is all about risk from a lender’s perspective, and banks consider the self-employed a higher risk than people with a regular job. You’ll pay more interest on a similar loan than you would with employment earnings. As a result, every borrowed dollar costs you more — sometimes much more.
You have two ways to mitigate this issue. First, look at the fine print on every loan you’re offered. Find the nominal APR (annual percentage rate) and the actual price you’ll pay after fees and escalators. Don’t be shy about negotiating if that price is high.
Second, form a meaningful relationship with the bank where you hold your business accounts. Know the manager’s name, and say hi to the tellers. When it comes time to negotiate for credit, this can grease the wheels.
2. Inconsistent Paychecks Can Lead to Missed Payments
You gave up a lot of things you didn’t like when you went to work for yourself, but one generally positive perks you let go of was predictable paychecks showing up on anticipated days. When you’re self-employed, your income ebbs and flows each month. It may be enough to get by, but it’s hard to set a budget with that kind of cash flow.
When business lags, it can get so low you have trouble paying all your bills. Missed and late payments go on your credit report, making it harder to get credit during the next slow patch — which means you have even more trouble paying your bills. This downward spiral can severely damage your credit and your business’s health.
You can solve this quickly by changing your relationship with your budget. Set a salary and pay it as W-2 income to yourself or take an owner’s draw. Base your monthly budget, including debt payments, on that amount. Any extra money you earn becomes a bonus once a month or once a quarter, which you can use for large purchases or fun indulgences. It takes a little organization upfront but is well worth the trouble.
3. Lenders May Need a Ton of Additional Documentation
When you’re looking for a loan as an employee, you just show a couple of pay stubs and tell the lender how to contact your boss to confirm that you work there. As a self-employed person, this process gets replaced by a much more in-depth look into your financial situation.
Your credit score won’t be enough proof that you’re a low-risk borrower. Lenders might ask for additional documentation such as a profit and loss statement, business plan, several years of company and personal tax statements, and even letters from vendors or your landlord. The process is more complicated and requires meticulous record-keeping.
Keep all of your records. Keep them up to date. Keep them well-organized and easy to find, both in hard copy and electronic format. If you already do this, the keep doing it. If you don’t do it, you’re in for some work.
Get a list of the documents lenders are most likely to want when you apply for credit. Over the next several weeks, locate the materials you have and create the documents you don’t have. Make them look sharp, and store them someplace where you can find them easily.
4. You May Be Targeted By Predatory Lenders
Predatory lenders love business loans. Regulations are more relaxed than those for personal credit, and the numbers can be much higher. You may have already received calls from them, offering you a high credit limit with unreasonably low requirements and stipulations. They’re more like loan sharks than traditional lenders.
These loans tend to take advantage of desperate or inexperienced business owners, trapping them in a cycle of minimum payments and high interest. Usually, they come with one or more deal-breaking aspects, such as:
- Exceptionally high interest rates (often more than 20%)
- Hidden costs and fees spiking the effective interest rate to levels that would otherwise be illegal
- A contract allowing the lender to debit payments from your account at will
Such conditions make for bad loans and can kill a business over time. Even if you make the payments faithful, these lenders often report late payments early and negotiate in bad faith. They can ruin your credit quickly, especially if you start to push back against their questionable policies.
Apply two simple rules to any credit offer you’re considering. First, if the lender called you rather than the other way around, you should be cautious. Second, apply the well-worn advice that anything that seems too good to be true probably is, and move on.
5. You May Lean on Personal Credit to Finance Business Expenses
Because business credit is expensive and hard to get, many self-employed people end up putting business expenses on personal credit cards. Credit churn happens when you’re constantly using a personal card to cover operational costs, including inventory, payments to vendors, and similar expenses, and then quickly paying that personal debt with business income.
This one’s not so much a problem as an opportunity with a downside. The churn puts you at risk of carrying a balance every month. When business revenues drop, that balance can harm your credit history by showing you’re borrowing more than you should. It also increases your business costs because you’re paying interest on those expenses.
As we said, it’s also an opportunity. As Tim Ferriss says in The 4-Hour Workweek, you can run those expenses through a card that earns cash back, air miles, or other rewards. As long as you keep your balances paid each month, the churn can net you meaningful savings, tax-free.
6. Your Reported Taxable Income May Be Too Low for Credit Applications
One benefit of being self-employed is charging some expenses to your business. Although you should never be abusive or dishonest, it’s common practice to drive a company car, expense office supplies, and apply part of your utilities and phone expenses to your business. These write-offs save on taxes but can cause credit issues.
For most self-employed people, the income they report on their tax returns doesn’t represent the buying power of their full earnings each year. This can be a problem when you’re trying to get credit and the lender wants to compare your reported income against the needs of the loan you want.
Unfortunately, there isn’t a reliable solution to this dilemma. If you report more income, you pay more taxes. If you report less income, your access to credit may suffer. Your best bet is to plan for your credit needs to the best of your ability. That way, you can at least adjust your tax strategy accordingly.
Follow credit best practices no matter what your employment status is
For anyone, self-employed or not, it pays to keep your credit score as high as possible and your credit report clean. But this is especially crucial for the self-employed. A high enough credit score can overcome or alleviate most of the problems mentioned above. Keep yours healthy and robust with techniques like:
- Checking your credit report regularly for problems
- Paying your credit card balances down to zero whenever possible
- Paying all bills on time
- Negotiating directly with lenders if you can’t avoid paying late
- Avoiding unnecessary applications for credit
- Keeping zero-balance cards open and on hand, even if you don’t use them
There’s no guarantee that getting all the credit you need will be a cinch, even if you're armed with a good credit score and reliable business records. But it’ll certainly be easier if you follow these tips and keep your credit healthy on a day-to-day basis.