Firstly, ask yourself:
- Learn the 5 C’s - The more you know the more leverage you
can use
- The 5 C’s should always be on your mind
- Don’t deviate from the 5 C’s - There is never a reason to
What are the 5 C’s of Credit?
The 5 C’s are short for the following: character, capacity, capital, conditions, and collateral. Lenders use each of these categories to measure a borrower’s creditworthiness, quantitative and qualitative.
Every loan a lender makes has an element of risk. The lender
uses the 5 C’s to determine the amount of risk an applicant presents. These 5
C’s tell a lender if the borrower is qualified for lending. The lender also
uses the 5 C’s when determining the loan's interest rate and credit limits.
Understanding the 5 C’s of Credit
Here is a discussion of the 5 C’s:
1. Character
A lender will refer to the applicant's credit history and
establish how often the borrower made payments on time to understand a
borrower's character. The lender will retrieve this information by pulling
credit reports and reviewing FICO scores. It is often worthwhile looking into how to check your business credit score.
A lender uses past behavior to predict the future likelihood of on-time payments and assess the borrower's overall credit risk. Character is a broad category and can also include a borrower's work history, references, credentials, and financial reputation.
2. Capacity
Capacity refers to the borrower’s ability to repay the loan
while meeting other debt obligations. The debt-to-income ratio, DTI, is
analyzed and used to measure this capacity. DTI is the amount of credit the
borrower used versus the amount of credit available.
The lower the DTI, the more favorable it is. Although each
lender is different, most financial experts recommend a DTI of 35% or lower
when applying for loans.
3. Capital
Capital refers to how much money the borrower is willing to
put towards the investment. For example, the amount of a down payment a
homeowner is willing to put down for a mortgage.
From a lender’s perspective, the more a borrower
contributes, the less risk the lender adopts. It also shows the lender how
serious the borrower is about taking on a loan. The amount of capital can also
affect the interest rate and repayment terms specified by the lender.
4. Conditions
Conditions refer to the applicant's financial stability and
how long they've been employed. But it can also refer to the loan conditions,
such as the interest rate and repayment terms. The use of the funds is another
aspect of "conditions" and can be used to make a lending decision.
5. Collateral
Collateral is an asset the lender might take possession of
if the borrower defaults on the loan. This type of loan is also referred to as
a secured loan option. Typically, the borrower provides the asset being funded
as collateral, for example, the vehicle in an auto loan or the home financed by
a mortgage.
When a borrower has collateral, the loan is less risky for the lender. As a result, collateral-backed loans often have lower interest rates and more favorable repayment terms. This refers to all kinds of small business financing, including equipment loans.
How do Business Lenders and Banks Use the 5 C’s?
Business lenders and banks use the 5 C’s to establish the
creditworthiness of borrowers. Using this gives a more comprehensive view of a
borrower and a broader sense of the overall risk of lending money.
Each lender uses the categories differently. Some lenders
apply a point system; others may give different weights to each category. While
a borrower may not know the exact method a lender is using, they can understand
what the lender is looking for and then work to improve their position within
each of the 5 C’s.
How a Borrower Can Improve Each of the 5 C’s
Here are some tangible ways to improve your finances, increase your business credit score, and increase your chances of loan approval:
- Increase capital with savings: Adding to your savings will
improve your assets, making you a more trustworthy borrower. You don’t
necessarily need to put all of your savings towards the loan (the capital), but
making some contribution will show that you are more likely to make your
repayments.
- Improve capacity by paying off debt: It improves your
overall ability to make loan payments when you pay down your debts. Paying off
debt can also improve your credit score, making it easier for a lender to
approve your loan.
- Boost character by making on-time payments: Payment history makes up 35% of your FICO score - the largest contributor factor to your overall credit score. When you make consistent, on-time payments, you boost character. Set automatic payment reminders if you have trouble remembering, or use automatic bill pay when possible.
- Use Credit Monitoring Services: Business credit monitoring services alert you to any changes in your credit score or any activity on your report. Using a monitoring system lets you stay on top of these changes, spot potential
errors on the report, and avoid any surprises. All three credit reporting
agencies (or credit bureaus), Experian, TransUnion, and Equifax, offer free and
paid monitoring versions. As a consumer, you are also entitled to three free credit reports per year, one from each credit bureau.
- Limit opening new accounts: Another method for improving
overall character is to limit your opening of any new accounts during the
application process. New credit accounts account for 10% of your FICO score,
which means this is one area you can easily pull back on to enhance how
credit-worthy you appear to lenders.
The 5 C’s and Business Loans
Understanding the 5 C’s could give you time to improve your
creditworthiness — especially if you are concerned about bad credit. Having bad
credit does not automatically count you out for business funding. However, by
improving your standing within each of the 5 C’s, you increase your chances of
getting the funding you need for your business.
One option for business loans for businesses with bad credit
is a lender like Credibly. Credibly offers multiple financing options,
including lines of credit, long-term loans, and SBA loans, all with repayment
options that can fit almost any business budget. Visit our expert review of Credibly to find out more.
