Easy Money!

One of the mistakes that many rehab investors make is using consumer debt for business purposes because it is “Easy.”

On the surface, the lowest hanging fruit for a rehab investor is the credit card or Home Equity Line of Credit (“HELOC”). Often these consumer credit facilities are used for repairs and even purchases of real estate.  Why go through the hassle of gathering information and approaching lenders for a loan that they will charge points, fees and potentially higher interest on, when you already have or can easily obtain a credit card or HELOC? The short answer is that using consumer financing for business purposes does not work long term. In fact, it can be lethal for you as a business operator and a consumer.

ImageSpecifically, this “Easy” financing methodology can have a very negative impact on credit scores.  For entrepreneurs in the rehab investor market segment, where capital availability is a critical success factor, the credit score is your most valuable asset.  It must be protected.

A credit score is determined using five main methods of analysis, payment history, amount you owe, length of credit history, new credit, and type of credit.  Amount you owe or utilization is impacted the most by using consumer debt for business purposes.

Amount You Owe

The second largest impact on your credit score is the amount you owe in relation to the credit limit.  It is also known as the utilization rate.   If you have borrowed and are near or at your credit limit, this damages your score. In fact, any balance above 40% of the limit has a negative impact on the score.  This is important for rehabbers because financing rehab projects takes a great deal of capital, which will most likely exceed that ratio.  High unemployment and the decrease of home values have prompted many lenders and banks to cut credit limits in order to minimize risk, resulting in an immediate increase of utilization rates.

Why Does It Matter?

Utilization rate accounts for 30% of your credit score. According to FICO Score Simulator, maxing out your credit cards could drop your credit rating from 700 down to 590 or worse, assuming that you still pay your bills on time and all other factors remain positive. According to myFico, “Carrying extremely high balances on all of your revolving accounts (i.e. credit cards, equity, and personal lines of credit) makes you look ‘maxed out’ on your available credit. It is often considered a high-risk trait by lenders and the FICO score.” In short, lenders (and credit scorers) don’t like high balances.

Make sure you understand how a loan or line of credit is being reported to the credit agencies.  Many “Business” lines of credits and loans actually use the credit score of the business entity owner(s) and reports to the agencies.  This means it has the same impact as a consumer loan.

So how do credit-reporting agencies distinguish between a shopping spree and a rehab project?

Well, they don’t. It is hard to blame them, however. This is because they report on 190 million consumers. Extremely few of these 190 million people are rehabbers, so it is impossible for credit bureaus to track the difference between consuming and investing on credit cards. When you purchase and pay for improvements on a property with your credit card, the agency cannot distinguish between that luxurious vacations, extravagant jewelry, expensive clothes, and pricey dinners.

Why are these credit scores important? It can make the difference between being able to obtain a loan and getting denied. Also, even if your score only drops several points, it can result in higher interest rates.