What are the 5 Cs of Credit?
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Character is referring to a person’s integrity, honesty, and good faith. Is this a person who does what they say and follows through on their commitments? If a borrower is one who will adhere to principles and stay determined to meet their obligations (i.e. – pay back their loan), they are generally considered to be of good character.
While “Character” is arguably the most challenging metric to measure (because it often lacks any numeric value), it’s also one of the most important, because it can often be most instrumental in the payback of loan than the other 4 Cs of Credit.
Even if the Capacity, Capital, Conditions, and Collateral of a deal measure out perfectly, it can all be for naught if a borrower is of poor character in the end.
The best way to judge a borrower’s character is over a long-term relationship. In the case of a first-time borrower (when a lender doesn’t have the luxury of a long-term relationship), they can supplement their limited knowledge by inspecting the person’s credit report, background check, talking with references provided by the loan applicant to gain further insight into the prospective borrower’s character.
Capacity is the borrower’s ability to generate enough revenue to satisfy their debt obligations.
Some lenders also refer to this metric as Cash Flow rather than “Capacity”.
Since loans are paid back from the net revenue generated by the borrower, a lender will look at the loan applicant’s ability to generate sufficient cash (which also includes their ability to manage their cash resources).
Capacity can be measured with formulas like the Debt-to-Income Ratio and the Debt Service Coverage Ratio, among others.
While some borrowers may show the ability to generate enough revenue to pay their debt service, they may have a history of using this money for purposes other than paying back their loans (like buying equipment or excessive inventory).
Loan underwriters can assess a loan applicant’s capacity by looking at their historical financials and comparing their financial performance with other businesses in the same industry.
It’s not as easy to assess the capacity of a new business or a newly constructed income-producing property, because there is no historical performance to evaluate. In these cases, the lender would have to make a decision with more weight on the borrower’s experience as a business operator in the relevant field.
Capital is the cash a loan applicant has on hand.
When a loan applicant has more capital on hand, they are in a better position to weather an unexpected financial hardship.
Having more “skin in the game” shows a higher commitment from the prospective borrower and a lower risk for the lender, because of the asset’s lower Loan to Value (LTV). When the prospective borrower has a lower amount of equity invested in their business and is already highly leveraged by other creditors, this is not a favorable sign in the eyes of the lender.
Conditions are the external factors that will influence the prospective borrower’s ability to meet their projections. These are forces outside of the loan applicant’s control, but they still need to be identified and acknowledged as a part of the overall risk assessment.
Some examples of external forces might be:
- The economy
- The industry as a whole
- Laws and regulation that affect the industry
- Changing social trends
- National and Global Politics
For instance, if a major employer in a small town shuts down their local plant and leaves thousands of workers unemployed, this will likely lead to a decreased population, which would increase the vacancy rate of rental properties in the local market and have an adverse effect on annual earnings of these rental properties.
One simple way to evaluate the conditions that might affect a business is to use websites like City-Data.com, BestPlaces.net, and Niche.com to find the population, unemployment rate, crime rate and other local market data that may impact the prospective borrower’s ability to perform as expected.
Collateral is typically the subject property being financed, which is also used to secure the loan.
Depending on what is being financed, and whether the lender requires additional collateral beyond the assets being financed, the lender’s collateral could consist of real estate, equipment, inventory, accounts receivable, stocks, bonds, cash accounts, life insurance, disability insurance or anything else of monetary value.
If a piece of real estate is being financed and the appraised value comes in lower than expected, the borrower could also pledge additional collateral to make up for this shortfall in real estate value.
While collateral is an important aspect of securing a loan, it’s important to remember that collateral is simply a means by which a lender can ensure they are made whole in the event of loan default. Collateral is not the source of repayment by itself.