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The 5 C’s of Credit: Banks Analyze for Creditworthiness

by Yigit Ozdamar
5 C’S OF CREDIT

The 5 C’s of credit evaluate a borrower’s creditworthiness. Creditworthiness refers to a borrower’s ability to borrow, use, and return money based on the agreed conditions. Financial institutions use this factor to determine one’s credit limit and the interest rate to charge on loan. 

They review five factors when evaluating a borrowers’ creditworthiness: character, capacity, capital, conditions, and collateral. The five C’s of credit apply to anyone applying for a loan or any other form of credit. More specifically, lenders assess the factors on these  types of people:

  • Business loan applicants: A small business owner applying for an SBA loan should improve these factors to as lenders use them to assess the credit risk
  • Future loan and credit card applicants: The application process of a credit card loan is easier if you have maintained good financial health with regard to these factors
  • Consumer loan applicants: The 5 C’s don’t apply to small business financing only but consumer lending products too. Such products include car loans, mortgages, and student loans

What are the 5 C’s of Credit? 

What the 5 C’s of credit entail is determining the risk of giving a loan to a borrower. Regardless of the type of financing required, the lending institution must perform a credit analysis governed by the 5 C’s:

  1. Character: Lenders want to know if the borrower and their guarantors are honest. They also need to be confident that the applicant has the education, background, experience, and knowledge to operate the business
  2. Capacity: the lender wants to know if the borrower or business can repay the loan. The borrower or business should have enough cash flow to repay the loan
  3. Condition: The financial institution also wants to understand the business, the economy, and the industry. As such, it’s essential to work with a lender who understands your industry
  4. Capital: You don’t want to solely rely on a loan especially if you’re starting a business. As such, the lender may ask about your investment in the business. Injecting capital in the company reduces the default risk. And, so is contributing personal assets. It shows your willingness to take a risk for the sake of the business
  5. Collateral: Since your business’ assets and those of your guarantors are secondary sources of repayment, the lender may ask about the collateral. Collateral varies based on the type of loan.  The next part of the article gives a detailed overview of each factor.

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The 5 C’s of Credit: Character 

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A borrower’s character is one of the most comprehensive aspects of the 5 C’s of credit. This is because an individual’s track record in credit management shows their character. Past defaults indicate negligence, an undesirable character trait when applying for a loan.

Remember the adage, ‘past behavior is the best indicator of future behavior.’ Lenders devoutly ascribe to this saying when examining a borrower’s character. Financial institutions use different approaches when determining a borrower’s character, but most of them assess one’s credit history.

The credit history shows a borrower’s track record of repaying debt. Financial institutions rely on credit rating agencies to obtain this information due to the degree of specialization required to compile a credit history.

There are three main bureaus credited with providing accurate credit reports: Equifax, Experian, and TransUnion. The reports show:  

  • The amount an applicant has borrowed in the past
  • If they’ve repaid the loans on time  
  • collection accounts and bankruptcies
  • Past lenders
  • Type of credit extended
  • Outstanding liabilities

Credit scores are assigned to express the individual’s creditworthiness, and the most common is the FICO Score. It consolidates data from credit reporting bureaus and calculates an individual’s credit score. FICO scores range from 300-850 and enable lenders to predict the applicant’s likelihood of repaying a loan on time. A high score indicates a lower risk.

Beyond your credit score, the lender may also look at your reputation, references, and how you’ve interacted with them. The lender may also evaluate your stability, e.g., how long you’ve lived or worked at your current job.

The 5 C’s of Credit: Capacity/Cash flow

Capacity shows the borrower’s ability to repay a loan. The lender compares their incomes against recurring debts using the debt-to-income ratio. It is calculated by adding the monthly debt payment and dividing the amount by the monthly income. 

The lower the ratio, the higher the chance of qualifying for a new loan. Many lenders prefer a DTI ratio of 35% or less, but it may vary by the financial institution. For business-loan applications, lenders review the company’s cash flow statement to determine the amount of income expected. 

If the business has unsteady cash flows, it’s considered a low-capacity borrower. Other ways of evaluating a borrower’s capacity include:

  • Debt-service coverage ratio (DSCR): It measures a business’s ability to repay debt by dividing the net operating income by total debt and interest payments.  This measure is more reliable when evaluating a business’ capacity because it shows if it’s generating enough income
  • Amount of excess cash flow: Lenders analyze cash flows to determine if the business has excess cash to repay debt obligations

The 5 C’s of Credit: Capital

The 5 Cs of Credit Capital

Capital represents all the assets under the borrower’s name. It comprises one’s investments, savings and assets like land and buildings. Lenders ask about one’s capital because it provides additional security if income or revenue is interrupted while repaying the loan.

For a small business, capital consists of personal investment, retained earnings, and other assets. Individuals, on the other hand, present savings and investment account balances as capital. 

Lenders determine an individual’s capital by calculating their debt to equity ratio. A low ratio indicates you’ve few debts hence a less risky borrower. Other measures lenders use to determine the amount of capital a borrower has are:

  • Loan-to-value: The metric compares the loan amount to the value of the asset you’re buying. For example, if you’re buying a car, the lender compares the car’s market value with the loan amount
  • Down payment percentage: The amount of down payment is calculated as a percentage of the total loan amount. Many financial institutions require borrowers to raise a down payment of 20%

The 5 C’s of Credit: Conditions

The 5 Cs of Credit Conditions

These are the specifics of the credit transaction. Lenders evaluate conditions in two ways:

  1. The condition of the loan, i.e., the interest rate, the principal amount, the purpose of the loan, and the loan term.
  2. External conditions including, the state of the economy, industry-specific legislation, prevailing federal interest rates, imminent political changes

While these conditions are beyond the borrower’s control, they indicate they increase the lender’s risk exposure. That’s why even borrowers with high credit scores might not access credit during a recession.

Conversely, during a booming economy, businesses are more likely to flourish; thus, borrowers are more likely to obtain credit. Some lenders also evaluate a business’ specific market. Companies in high-risk industries are less likely to get credit if they fall under the lender’s prohibited industry list.

Most of these conditions are beyond the borrower’s control, but they can determine the business’s strength and how the loan application appears. The best way to maintain control over the loan application process is to have a plan. 

Lenders want to hear what you want to do with the loan. Don’t just say you need $50,000 for your business, be specific. Some reasons for applying for a loan include:

  • Hiring new employees
  • Business expansion
  • Purchasing inventory
  • Buying equipment
  • Increasing cash flow

It would help if you also got the timing right. Many small businesses make loan applications when they are facing a cash-crunch. It shouldn’t be the case. The best time to apply for a loan is when your business is booming, and the economy is good. A recession is likely to affect a business’s cash flow, reducing your loan’s chances.

The 5 C’s of Credit: Collateral

Collateral is an asset(s) a borrower pledges as security for a loan. Generally, secured loans are considered less risky than unsecured ones, hence more likely to get better terms. Individuals applying for loans pledge fixed assets like vehicles, homes, or savings, while business owners pledge equipment or account receivable. 

If pledging fixed assets, the lender evaluates their value by deducting the value of the current loans secured through that asset. The remaining equity is the actual value of the collateral. Some lenders also require a personal guarantee. This means you will be liable for the loan in case of a default. 

As such, it’s essential to research each lender’s policy requirements regarding collateral. If you aren’t comfortable with some conditions, shop around until you find a lender suitable for your business.

Besides, you can apply for an unsecured loan if you don’t have enough collateral. Before applying for an unsecured loan, ensure you can pay it off within a reasonable time. This is because unsecured loans attract higher interest rates; the longer the loan term, the higher the amount paid.

The 5 C’s of credit are the most important factors lenders evaluate when borrowers apply for loans. Improving on each of the characteristics goes a long way to securing a loan with a lender.

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