Table of Contents
- Lenders assess five aspects of your financial welfare: character, capacity, capital, collateral, and conditions.
- You can lower the risk for the lenders by paying down past debts or committing collateral to the loan.
- When lenders see you as a low-risk borrower, they’re more likely to agree to lower interest rates and better terms of repayment.
- Financial advisors can help you navigate the lending process.
If you’re a small business owner looking to borrow from banks and lenders, you need to master the five Cs of credit. These consist of character, capacity (to repay your loan), capital (how much you’ve invested in your business), collateral (assets to guarantee repayment in case you default), and conditions (of the loan and the wider market).
While all five of these aspects are usually considered by lenders, there are no hard and fast rules about which one is most important. That means that one lender may place more emphasis on character while another focuses on collateral.
Lenders may disclose which aspects they look at most closely, although many don’t. If possible, you should constantly try to improve all five Cs of credit so that you aren’t relying on one and hoping the lender doesn’t notice another.
In the context of credit, character refers to your trustworthiness and credibility. If your credit score isn’t outstanding, or you’ve run into financial hardship, it’s an opportunity for your winning personality and steadfast history to shine through.
Character is assessed by looking at your work history, credit reports, credit scores, references from other lenders, and general reputation. If you’ve demonstrated in the past that you’re responsible and make your payments on time, lenders will be more likely to do business with you.
Character tends to be more highly considered by small community lenders who get to know their borrowers. If you can build a relationship with your bank by sharing news about your business, so much the better. Banks like responsible borrowers who are likely to repay loans.
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Capacity is your ability to repay the loan you’re asking for. It’s important for lenders to choose borrowers that they find reliable and can repay a loan. Capacity looks at aspects of your financial health, like cash flow statements, how stable your income is, and where the money comes from.
Another important financial metric is called Total Debt Service Ratio (TDSR). It’s a borrower’s total debt obligation divided by gross income. If a high percentage of your gross income is already committed to pre-existing debts, lenders may be less likely to extend another loan.
If that’s the case, it’s recommended to work on paying down existing debts until you free up more of your gross income to go toward your new loan.
Capital refers to how much money you invest in your business. When borrowers invest their own money or capital into projects, it indicates that they are committed to making the venture succeed and have a vested interest in doing well.
Your net worth (total assets minus total liabilities) can be an indicator of your capital. This is important because your business might not have a ton of money in the bank, but your net worth includes other types of assets that lenders consider.
There are many ways to demonstrate capital for individuals and businesses. One well-known example is mortgage down payments. It could also include machinery, patents, human capital (employees), and other things that keep your business running.
Collateral is the means of assuring the lender that the borrower can repay the loan. Most people, even businesses, don’t necessarily make enough money to pay back a loan, but they likely own assets that can be used as collateral. That way, if they can’t pay back the loan, the lender knows the assets can be sold to repay the loan.
When you can commit collateral, it reduces the risk of you defaulting on the loan. Lenders would usually rather give low-risk loans, and they may be willing to improve the terms in your favor if you have suitable collateral. They may lower the interest rate on the loan in return for collateral.
There are many assets that can be used as collateral. Some of the most common include real estate properties and vehicles, but they aren’t the only options. A mortgage, for example, uses your house as collateral. That’s why if you can’t make your mortgage payments, the bank forecloses on your house.
The conditions of a loan refer to aspects of the loan you’re seeking, such as the length of time you’ve worked there, how long the business has existed, how well the industry is doing, the interest rate, the loan’s purpose, loan amount, and what financial experts are predicting for the future.
Loan amount influences a lending decision in the most obvious terms: lenders may look more favorably at a smaller amount. Higher interest rates are beneficial for lenders, so they may overlook other disadvantages. Similarly, longer repayment terms are better for lenders because they have the chance to make more interest.
Loan purpose is also important. For example, a loan for the purpose of increasing cash flow to buy more merchandise for a company that’s projected to sell quite a lot in the coming months is more likely to be approved than a loan for renovating an apartment building to sell when the housing market is projected to fall.
Importance of Understanding the 5 Cs
Understanding why lenders make their decisions about loans and how they set their repayment terms is beneficial for borrowers to help them get the best terms possible. Knowing how to improve each aspect of your five Cs can put you in an advantageous position when you’re negotiating your loan and make you more likely to get approved.
In some cases, it may be beneficial to have the help of a financial advisor to guide you through the lending process. Financial advisors educate their clients and help them plan. They can determine which aspects of the five Cs you need to improve before asking for a loan and advise you on how to proceed.
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The five Cs of credit are the criteria lenders use to evaluate a potential borrower and decide what (if any) loan terms are appropriate. They exist so that lenders can look at different aspects of financial health and determine the risk that the borrower will be unable to repay the loan.
For lenders, counting on borrowers to repay the principal amount and interest in a timely manner is of the utmost importance. Evaluating your character, collateral, capacity to repay, conditions of the loan, and your capital is the best way for them to decide whether to trust you.
If you know what lenders are looking at, you can take steps to make yourself more appealing as a borrower by paying down other loans, committing assets as collateral, establishing a relationship with your bank, improving your credit score, and investing in your business.
Find out more
- Understanding Credit Scores: To complement your knowledge about the 5 Cs of Credit, gain insights into What Affects Credit Score and how these factors play a crucial role in determining your creditworthiness.
- Building Credit Efficiently: If you’re looking to apply the principles of the 5 Cs in building your credit, explore strategies in How to Build Credit Fast, which offers practical steps to enhance your credit score quickly.
- Credit Monitoring Services: To keep track of how well you’re managing the 5 Cs of Credit, consider using Best Credit Score Monitoring Services to monitor your credit score and get alerts on any significant changes.
- Repairing Credit Issues: If you’ve identified areas needing improvement in the 5 Cs, learn about How to Fix Your Credit for effective ways to address and rectify credit issues.
- Credit Score Fundamentals: Deepen your understanding of credit scores by comparing FICO vs VantageScore, which are two major scoring models that interpret the 5 Cs differently.
- Credit Repair Companies: Should you need professional help in managing your credit, discover the Best Credit Repair Companies that can assist you in improving your credit based on the 5 Cs framework.
- Credit Repair Costs: Understand the financial aspect of credit repair with insights into Credit Repair Cost, which is crucial for budgeting and planning your credit improvement strategies.
- Credit Score Education: Lastly, for a comprehensive understanding, check out What is a Good Credit Score to see where you stand according to the 5 Cs and how you can aim for a higher score.