Study: Racial biases continue to impact loan approvals for minority business owners

It has been a struggle for minority business owners to obtain access to capital. As data from the Federal Reserve System shows, more white applicants (35 percent) get all of the financing they apply for compared to Hispanic (19 percent), Black (16 percent) and Asian (15 percent) business owners.

A recent study in the Journal of Marketing Research revealed that Black business owners have a harder time getting financing for their companies than white business owners — even when they have a stronger financial profile.

While seeming to confirm the racial disparity in lending, it wasn’t all bad news when it came to business loans for underserved communities. The study revealed that when Black business owners had a more sophisticated business structure, like a corporation or limited liability company (LLC) rather than sole proprietorship, approval rates flipped, favoring Black applicants.

In other words, the findings from this study might help people who have struggled to get minority business loans. Read on to learn more about how racial bias continues to impact business loans for underserved communities — and what minority business owners can do about it.

2023 study results show minority entrepreneurs continue to face discrimination in lending

In the past, lenders did not have to collect or report data about the race, ethnicity or gender of applicants seeking business loans. The U.S. Small Business Association’s weekly lending report is one of the only reports that provide insight into lender approvals based on such demographics.

The Consumer Financial Protection Bureau’s (CFPBs) new rules dictate that banks need to report data on the demographics and income of small business loan applicants. But it will take at least a few years before the data is released to the public.

In the meantime, researchers took matters into their own hands. A new study published in the Journal of Marketing Research looked at business loans for historically marginalized communities, specifically, Black business owners. Using field data, it compared their experiences against white business owners with four different sub-studies:

Let’s take a look at the most significant results of the study.

Minority customers offered less favorable loans despite having stronger financials

Study one looked to see if Black business owners with “greater business income, more years in operation, more money in the bank and higher credit score” would be presented with the same financing options as white business owners.

They were not.

In the study, bank employees usually recommended a home equity line of credit (HELOC), a business line of credit (BLOC) or both. HELOCs are generally more expensive (come with more fees) and riskier because they require the borrower to put up their home as collateral. Long story short, BLOCs are the more favorable of the two.

Study one showed that while bank employees recommended HELOCs at about the same rate to Black and white customers, they recommended the more desirable BLOC “significantly less often to Black (vs. white) customers” even though the financial profile of the Black customer was stronger.

As the study concluded, “Black customers were less likely to be offered the less expensive, less risky, more flexible offering.”

The study also asked test subjects to report on their experience at the bank. In open-ended responses, white participants reported feeling encouraged. Black respondents reported less positive experiences — from difficulty getting the information they wanted to bank employees stating they were “unqualified” to help them.

White customers with low socioeconomic profiles treated more favorably than Black customers with similar profiles

Study two looked to see if fewer business loans were approved for underserved markets because of the individuals’ socioeconomic status (SES) in those markets.

It grouped participants into four categories based on two distinct favors: SES (low vs. high) and race (Black vs. white). This lets us see if the behavior of bank employees was racially motivated or if their perceived link between race and SES was the main driver — and consequently shaped their thinking in determining if that individual was a good customer for the bank.

The study specifically looked at the warmth the employee demonstrated. For example, did they ask for the caller’s name and use that name? Did they ask how they can help? SES did not impact the warmth levels white callers reported. Among Black callers, though, “those with lower SES experienced significantly fewer warmth behaviors from employees.”

And while white customers with low SES reported only a slightly lower evaluation of the employee’s competence, “for Black customers, those with lower SES perceived significantly fewer employee competence behaviors.”

Ultimately, the study “demonstrates that Black customers have a worse service experience than white customers,” especially when they have low socioeconomic status.

With an LLC, 75% of Black business owners had their loans approved

While business loans for historically marginalized communities can be difficult to secure when you operate as a sole proprietorship, the study showed choosing a more sophisticated business structure dramatically shifts your odds of approval.

Specifically, when applying for a loan as a sole proprietorship, 60 percent of white applicants were approved, but only 26 percent of Black applicants were.

But if that applicant was operating a business as a limited liability company (LLC), S-corporation or C-corporation, the numbers flipped. In that case, 75 percent of Black applicants secured financing, but just shy of 42 percent of white applicants did.

In fact, a release from Brigham Young University (BYU) — from which one of the study’s authors came  — specifically recommended that Black business owners “spend $45 to register their company as an LLC, which potential lenders see as an outside indicator of sophistication.” This way, you may have an easier time getting the LLC loan you need.

How much does an LLC cost?

As the study pointed out, around 80 percent of businesses across the U.S. operate as sole proprietorships because they’re easier and cheaper to start and maintain.

Setting up an LLC or corporation usually requires an initial filing fee plus maintenance costs. These fees vary by state. For an LLC, initial filing fees range from $40 to $500. In some states, you need to file an annual report as an LLC, but there’s no yearly fee. Others charge an annual fee, with some in the hundreds of dollars (up to $800 in California).

But that extra money and paperwork can make it easier to get approved for minority business loans. And since getting an LLC loan with more favorable terms can keep more money in your business in the form of lower fees and less interest, the LLC filing fees may pay for themselves.

Bottom line

If you’re a minority business owner looking for business loans, operating as an LLC or corporation can make getting the financing you need easier. But it’s also important to consider your financial profile. Credit score, time in business and the revenue you have deposited in a business checking account are important factors lenders look at when considering loan applicants.

To help improve your chances of approval, it’s important to search for lenders that fit your financial profile or work with lenders that specialize in helping businesses in underserved communities. These types of lenders include Community development financial institutions (CDFIs) and Minority depository institutions (MDIs).

If you work for a lender, this study provides actionable insights. You can:

• Develop policies to ensure employees offer business loans uniformly to all customers
• Have at least two employees independently evaluate loan applications
• Explore offering special purpose credit products (SPCPs) to proactively combat racial discrimination
• Train your team on Equal Credit Opportunity Act (ECOA) compliance
• Use technology to reduce bias. For example, let customers apply for loans online rather than in-person

This might seem like a lot of work. But as the study points out, leaving things unchanged in the financial service sector exposes lending institutions to negative outcomes, such as employing individuals with racial bias, losing the loyalty of minority customers and losing viable business and profit.

Frequently asked questions

• What is an underserved small business?

  These businesses fall outside banks’ historically core market of white, male-owned companies with a decently sized workforce. They could be located in a rural area, sole proprietors or minority-owned, for example. Business loans for underserved markets are generally harder to come by, as this study underscores.

• Why is access to capital important?

  Without working capital to use, business owners can’t seize opportunities and scale their businesses. They may be unable to start or grow a business, buy a key piece of business equipment or bring on new headcount to handle an uptick in orders, for example.

• What is one of the biggest challenges for Latino-owned businesses?

  Latino-owned businesses are 50 percent more likely to seek financing than white-owned businesses but are less likely to get approved for loans over $50,000. In other words, one of the biggest challenges among Latino business owners is access to the capital they need.

• Is a sole proprietorship easy to finance?

  No, generally, other business structures make it easier to secure financing. A partnership or corporation can make it easier to raise financing by issuing equity, for example. And an LLC or corporation status can make it easier to get a loan, especially business loans for underserved communities.