Creditors don’t want to lend money to everyone who asks for it. They want to know if borrowers can repay them.
For that reason, they use the five C’s. These help them determine whether they should provide a borrower with money.
The five C’s describe the characteristics of the lender-borrower relationship. It is a loose system creditors use to estimate whether the borrower will go into default. It is also used to assess the risk of financial loss.
Capacity measures the borrower’s financial ability to repay the loan. That’s because creditors want to ensure a borrower has sufficient ability to repay.
For instance, banks may ask questions about a borrower’s personal spending habits and existing outstanding debt when they apply for a mortgage. They do this to check they have sufficient funds available to repay monthly installments.
In the U.S., lenders usually require a low debt-to-income ratio to take out larger loans. For instance, lenders prefer debt-to-income ratios below 36 percent for new lending and below 43 percent for mortgage lending.
Some lenders will also consider the capital a borrower is willing to put towards an investment, such as a house or business. The more they risk, the more confident the lender can feel about their relationship with them.
In the mortgage market, a higher down payment results in a lower interest rate on the outstanding sum. Down payments over 20 percent usually attract the lowest rates. In business, offering more capital upfront for a venture can encourage lenders to take additional risks because they know the borrower has skin in the game.
The third of the five C’s is collateral—or the value of assets the borrower already holds. Lenders look for collateral on some loans because it enables them to recover losses if the borrower defaults. For instance, if a borrower does not repay their mortgage, banks and lending institutions can repossess their properties and sell them.
Loans with collateral are often called secured loans and carry a lower interest rate. That’s because there is less risk for the lender. If the borrower cannot make repayments, then the capital value is usually still safe (sometimes this doesn’t happen, as in the financial crisis when the underlying collateral also lost significant value).
The fourth C for credit is “conditions.” Again, these affect how much a person can borrow and at what rate.
Common conditions include:
Lenders may observe that a person has high income and assets, but they may reject a loan application if they cannot meet their conditions.
Lenders may also take into consideration factors outside of the borrower’s control. These could include things like current regulations, the general state of the economy, or their balance sheet situation.
Historically, lenders would gather information about borrowers through interviews and use it to judge their character—an indication of how likely they are to pay the money they owe on time and in full. However, today the term “character” refers to the borrower’s credit report, according to data gathered by credit bureaus.
These organizations—such as Equifax and Experian—collect data concerning borrowers’ credit history. Then, they use this information to assess their likely creditworthiness. Whenever an official lender enters a relationship with a borrower, they consult their reports to decide whether to arrange a loan and the interest rate to charge.
In light of the five C’s, there are some essential questions businesses should ask before applying for credit.
The first consideration is whether the business is following all relevant laws and regulations at the local, state, and federal levels. Lenders may not be willing to lend to companies at risk of legal action or those breaking current laws.
Many business lenders conduct in-depth analyses before agreeing to lend to companies. They may request audits or decide not to lend money depending on the industry or threats they perceive.
You’ll also want to ask whether you've studied your competition and industry trends before asking for money. Lenders may be unwilling to provide credit if they believe rivals are too strong or the industry is failing as a whole.
For instance, today’s lenders are pulling back from certain sectors being disrupted by new technology. They may also refuse to lend money if there is an established market leader and your business cannot disrupt it or offer anything new.
Whether you provide a needed product or service is another vital question if your business wants to borrow. Creditors will want to know if there’s a demand for what you offer because this is how you will repay them. Customers will buy your products and services, and some of that money will go to investors.
Lenders may have different opinions regarding the viability and profitability of your business. As you explore your options, you will discover that some are friendly, and some aren’t. Often, it’s just a matter of finding the right partner who understands your business model.
Lastly, you’ll want to ask whether you’re committed to making your business succeed. Lenders want people of strong character who can see tough projects through to the end.
Be honest with yourself about your motivations and commitment to your business. Are you passionate about it, or will you look for an exit after a few months?
If you want to find out more about borrowers’ credit information before lending to them, explore our options at Softpull Solutions. These can help you determine risk quickly to make better decisions.