This post is a prelude to next week’s post about Prosper and personal and small business loans loans via peer to peer lending networks (to give you a preview, I am looking at the loan documents provided by Prosper and translating them into plain English). However, with certain regions of North America in a full-out recession, it is topical to address the best way to obtain a personal or business loans from traditional and non-traditional lenders. There are two contradictory trends occurring if you are looking for a loan- money is getting cheap with interest rates going down but lenders are becoming increasingly stringent in who they lend to (”there is more good money than good deals” as the bankers like the say; typically a sign we are at the end of a economic cycle). Thus, attempting to obtain a personal or small business loan is increasingly become an art and lenders are not handing out (stupid) money like it was 2004 all over again.

Having represented lenders in a past-life, sat on loan review committee and lent money in business, here are a few tips to increase your chances of obtaining a loan:

COME PREPARED

Run your own credit score first and clean up anything that can be cleaned up. Obtain letters of reference from other people you have borrowed money from, employers, banking reference (you usually have to pay for this letter) etc. Find your tax returns from the last three years. Compile all the data to complete a net worth statement.

In other words, have your documents ready. Even p2p lending groups like Prosper, which require minimal paperwork, still requires you to dig up some documentation about yourself (like your social insurance number).

Never, EVER, say you need money NOW

To a lender, the phrase “I need money now” sends warning flags up. Why are you in such a rush to get money? Is another creditor after you? Are you behind on other types of payments? Are you desperate? Desperate people do desperate things including lie on their loan application. The practical consideration is that lenders need to conduct due diligence before they make a loan. This takes time (the amount of due diligence a lender has to conduct is the same for a $10,000 loan as it is for a $200,000 loan- this is why lenders tend to shy away from smaller loans).

Plan ahead. If you need money 30-45 days from now, start applying for loans now. Most lenders, even the non-traditional ones, need at least 2-4 weeks to look at your application, interview you, arrange to transfer money to you etc. (I am not talking about payday loans).

WHAT’S IN IT FOR THE LENDER?

What is the difference between investing in equity (stocks) and debt (lending people money)? In equity, you are foregoing certainty on a return on investment for upside potential (save for dividend payments). In debt, the lender seeks certainty of payment in exchange for foregoing upside potential (I am not including convertible debt instruments). Most borrowers fail to appreciate this difference and this difference sometimes costs them a loan.

A lender is not particularly concerned that you could take a $5,000 small business loan and make $200,000 with it. The lender’s primary concern is that they get the $5,000 back at maturity and the interest payments are paid on time. When applying for a loan tell the lender how it will be paid back. Most borrowers spend all their time telling the lender how it is going to spend the loan proceeds. (this raises the question of what’s in it for the lender for borrowers on Prosper who need money to go on vacation- um…). The story you tell cannot be all about you- address what’s in it for the lender.

I will give you an example. I once heard of a private individual who lent money to people to buy cars no matter how bad their credit score was. All the borrower had to do was show the lender that they needed the car to work- either as a traveling salesmen or the job was not accessible by public transit and prove that this job paid enough to pay back the loan after all other expenses (i.e. show a pay-stub, get a letter from the employer etc). The theory behind this loan criteria was that the lender (who I never met) believed someone would bounce a rent cheque before their car loan since the car was absolutely essential as a means of producing income. The lender made the borrower show what’s in it for the lender since they had to prove that the loan was being used to generate income which would increase the chances he got paid.

DELIVER THE BAD NEWS TO THE LENDERS FIRST

There is an old saying in politics- be the first to deliver the bad news. The same rule applies to applying for a loan. If you have a skeleton in the closet (bad credit score, taxes outstanding, behind on support payments), reveal it during the application and provide a plausible and reasonable story on why this is not an issue (I was young and didn’t used my credit card improperly but that was 5 years ago, I have a payment plan set up with the tax authorities etc. etc.). If the lenders have to find this out during their due diligence period, it slows down the application process and a borrower has a better chance of crafting a story around the bad news and mitigating its impact then the lender finding out this surprise and jumping to its own conclusions.

WHAT HAPPENS IF YOU DON’T GET THIS LOAN?

This is a typical question that a lender will ask a borrower. The wrong answer is “its this loan or bust!” In a small business context, the lender is trying to ascertain whether you will put your own money into the business and share in the risk. In the personal finance context, the lender is looking for the same thing- will you come up with more of your own money to buy the house/car/boat etc.; the more money you have in (or the more lenders you find), the less the risk for the lender (and, hence, the entire problem with subprime- the borrowers had no risk having put no money down…).

HAVE YOU SHARED THIS RISK WITH THE LENDER?

To dovetail on my last point, the worse type of borrower is the one who is proposing that the lender put up all the money (and financial risk) and the borrower puts in nothing. Let me put it this way: you go to Vegas and the house gives you $10,000 free as opposed to you putting in $5,000 and the house giving you $5,000. You have one hour to gamble and, at that point, you have to return the free money whether it is the $10,000 or $5,000. Will your betting pattern be the same with $10,000 free or half of your money at stake?

The reasoning behind the borrower “putting skin in the game” is simple: if you have money in, you have shared in the risk. For entrepreneurs, sweat equity is often discounted as skin in the game so keep that in mind. The more risk you have/the more money you are putting in yourself the greater you will want to pay off the loan and the more likely the lender will look upon you favorable and give you a favorable loan term.

For larger loans or loans obtained to acquire assets, collateral will be required. Collateral is a guarantee (usually an asset) to secure the payment of the loan in the event of default (i.e. I take your car if you default on a payment). This is called a secured loan and is probably a much larger topic onto itself. However, the point is you have to show you have a personal stake if things don’t go well. If there is no personal stake then, well, you get subprime and its assorted messes.

Just one final note: lenders may reject your loan for reasons that have nothing to do with you. They may have reached their loan quota, be low on money (remember that lenders have lenders), have too many of one type of loan etc. Don’t take a rejection personally- perfectly good loan candidates can be passed up. Don’t burn your bridges. A lender may remember your professional conduct the first time you applied and give you the benefit of the doubt the next time you approach them for a loan. Good luck.

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On March 13, 2008, I wrote “….I waiting for the other shoe to drop and have some mid-tier financial institution go under; every bubble seems to have some semi high-profile causality which usually marks the bottom.” On March 14, Bear Stearns required emergency funding and, last night, JP Morgan Chase acquired the firm for $2/share (financed by government money). Wow, that was fast. Unfortunately, we are no where near the bottom. Best not to watch bank stocks on the short term.

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I am on business travel this week so there will be two guest posts this week and no posts on Thursday or Good Friday. I have guest posted at Million Dollar Journey on the Smith Manoeuvre (SM), the Lipson case and audit risks of the SM. Thanks for the opportunity FT. I understand it is running this Wednesday. Hope you enjoy it.