When individuals and small businesses apply for a loan, lenders use your credit report and a system called 5 C’s of Credit to analyze your creditworthiness as a borrower. This method of analysis weighs 5 important characteristics of the borrower to carefully gauge the reward or risk of the loan transaction.
What are the Five C’s of Credit?
The 5 C’s of Credit stands for character, capacity, capital, collateral, and condition. It is a system of qualitative and quantitative assessments that lenders use before deciding on what loan program to offer you and at what rate.
Finance-wise, your character is reflected in your credit score. This characteristic shows how trustworthy you are as a borrower and how well you manage your debt.
Lenders make a careful analysis of your capacity to repay your debt obligations. They look at your cash flow and any other financial assets that constitute your liquidity in general.
This refers to any valuable asset you are willing to pledge as insurance in case of default. In instances where you are applying for an unsecured loan where collateral is not required, the 4 other characteristics will have a higher level of importance.
This refers to how much money you have put toward the investment. Lenders measure your leverage by the amount of money you put in.
Lenders analyze your purpose for the loan along with the current market and economic conditions at the time of your application. The size of the loan, the projected interest rates, and the industry are just some of the factors lenders consider to study this characteristic.
What Lenders Look For in 5 C’s of Credit?
Lenders make a careful evaluation of the 5 C’s of Credit by creating point systems for each characteristic. They are looking at several parameters to determine your eligibility for a loan.
Lenders take a hard look at your personal and business credit reports and scores. If you’re applying to fund business expansion, lenders would like to know how long you’ve been operating your business as well as its integrity in the market or industry it belongs to. They are keen on finding out if your business has true potential for long term growth. Your personal attributes are also being considered and analyzed; lenders may go as far as doing interviews with personal references as well as people that work within your business.
Lenders look at your overall capacity to repay the loan by analyzing your cash flow from secured income from your job or business. They also look at any type of investment income such as dividends, incoming financial support from family members, and capital gains from liquidated assets.
Lenders will require a specific type of collateral for a specific type of loan. They want to know how much value your assets will grow during the duration of your loan’s term in case they need to be liquidated due to default. Some examples of collaterals include properties, vehicles, equipment, fine art and collectibles, paper investments, savings account, and jewelry.
If you’re borrowing money for business purposes, lenders will want to see how much you have invested in your business and how you’ve managed that money. If you are willing to put a good amount of money toward the loan, they see you as a more favorable risk.
Lenders analyze the principal, interest rate, and monthly payments to determine if you can practically take on the loan, whether it’s for personal or business use. They base their analysis on the economy (current condition and outlook), the industry of your business, the stage it belongs to in the market lifecycle, and how strong your cash flow is.
How to Master the 5 C’s of Credit
A big part of your financial journey is made up of credit and credit management. If you want to build creditworthiness so that applying for a loan is quick and easy, then you need to learn how to master the 5 C’s of Credit.
- Be professional in all of your business dealings especially with your bank. By doing so, you’ll create a network of people that can vouch for your good attributes that are important to lenders.
- Raise your credit score on a level that means “creditworthy” to lenders. Focus on improving your score based on the factors that have the highest impact.
- Understand your credit report and take action to correct any errors on it.
- Increase your income by taking a practical side job that you can keep for the duration of the loan you are applying for. Likewise, cut luxury expenses to a bare minimum so when lenders analyze your cash flow against your expense they will see a good amount of money available to repay your loan.
- Pay down past debt. This will lower your debt-to-income ratio which also improves your credit score.
- Increase your capital investment. You may seek financial assistance from a personal or business network. You could also venture into an income-generating project to save enough cash for capital.
- Highlight your success especially if the loan is to be used in your small business venture.
- If the loan is to be used for a new venture, be sure to support it with documents that are devoid of any speculation or market risk.
- Make a complete list of your assets and carefully appraise their value. Seek a professional for practical assessment as necessary.
- Most lenders would require a blanket lien over your assets; carefully decide if you are comfortable with it.
- Find a lender that suits your goal and loan needs and doesn’t require a personal guarantee.
- Apply for a loan at the right time or when the economy is good.
- Make a clear written plan on how you will use the funds especially if it is for business purposes. To raise the confidence of your prospective lender, be sure to highlight the business resilience and all measures you have in place to address all types of risks.
- For business loans, improve your debt-service coverage ratio. Lenders pay careful attention to the difference between your available cash flow that pays current debt obligations.
Knowing the importance of the 5 C’s of Credit as an important system that lenders use for all types of borrowers will help you get ahead of each lending process you take. Focus on how you can improve on each of 5 categories to make it easier to get the credit you need.