When underwriters and creditors consider your loan or credit application, they take several factors into account, including the 5 C’s of credit.
The 5 C’s of credit are 5 of the most important considerations that lenders have when evaluating your financing application. Let’s learn more about each of 5 C’s to help you secure the funding your business needs to reach your goals.
What Are the 5 C’s of Credit?
Lenders analyze 5 main factors when you apply for business credit. Known in the industry as “the 5 C’s of credit,” these considerations are applied whenever a creditor decides whether issuing a loan passes an acceptable risk threshold.
The 5 C’s of Credit
Capital refers to the amount of money you need to put toward the loan or investment.
Think of a down payment on a mortgage—when you place a 4% down payment on a $500,000 home, you are offering to put up $20,000 in capital on the mortgage. Putting up larger amounts of capital on a loan or investment increases the lender’s confidence in your ability to repay it.
Generally, the higher your down payment is, the more likely that you will get approved for the mortgage. The same rule applies to credit borrowing because the more money you have to secure it, the greater your chances of approval.
Collateral is the capital or assets that a borrower pledges to secure a loan. Putting up collateral reduces risk for the lender because they can take possession of the collateral if the borrower defaults on the loan.
When loans are backed by collateral, they are often referred to as “secured loans,” which can be secured by either the business or an individual through a personal guarantee.
One of the main benefits of a secured loan is that they’re typically offered at a lower interest rate. In other words, putting down a deposit in the form of collateral can reduce the amount you pay for the loan over time.
If you lack an impressive credit history, it could be in your best interest to set aside assets to offer as collateral.
Character in lending is just that—the character, or integrity, of the borrower.
When considering applicants for a loan, lenders tend to shy away from people who operate shady businesses with poor FICO scores. Instead, they would rather lend to transparent companies that have positive reviews from customers and the media, with impressive scores from risk analysts and credit bureaus.
If you want to keep your chances of approval as high as possible, we suggest taking the following critical credit factors into account. Whenever you apply for a business loan or a business line of credit, these “character credentials” can make or break your eligibility:
- FICO score (i.e., 550 or above)
- Number of years in business
- Number of credit applications filed in the last 9 months
- Collections and liens over the last 7 years
- On-time payment history
While a loan’s conditions can often refer to its principal amount, interest rate and repayment term, it also means the factors within your business—and industry as a whole—that can impact your ability to repay your loan.
Your lender wants to know the financing is being obtained for responsible reasons that won’t hurt your ability to make repayments. For example, expanding your business and financing equipment are appealing conditions to lenders because they could help your business remain competitive, better serve customers and ultimately generate more revenue.
However, there are several other conditions that can make a lender reconsider financing your business, and sometimes they’re factors outside of your control. If your business operates in an industry that is oversaturated with competition or in an overall decline, lenders could see these conditions putting you at a greater risk of defaulting on a loan.
The old maxim of “know thyself” can prove useful even when applying for business financing. Knowing what are the 5 C’s of credit begins with understanding one’s capacity to repay your loan or another form of financing.
First, you should know what your debt-to-income (DTI) ratio is. This metric considers your business’s annual income and measures it against your recurring debts to provide you with a figure to determine how easily you can pay off additional debts.
To find your DTI ratio, check your balance sheet and plug your business’s financial information into the following formula:
DTI Ratio = Recurring Monthly Liabilities ÷ Gross Monthly Income
To give you an idea of what DTI ratio is desirable, most national banks will refuse to approve a mortgage for any applicant with a ratio of 42% or higher. Ideally, you’ll want your DTI ratio to be under 35% to be in the running for most loans.
Why Are the 5 C’s of Credit Important?
Lenders—whether they are small business creditors or mortgage lenders—always want to minimize risk. The lower the risk to the lender, the more likely it is that your application will be approved.
Your best bet when it comes to getting your credit application approved is to master the art (and science) of the 5 C’s of credit in the lending industry. Keeping tabs on your FICO SBSS, personal and business credit history, as well as business collateral (such as equipment, inventory, accounts receivable and real estate) can go a long way toward maximizing your creditworthiness.
Remember that the 5 C’s of credit are also a holistic approach to evaluating financing applicants; intangible factors such as business reputation and flexibility are as important as credit history.
Creditors don’t want to feel as if they’re gambling on your business; they want their investment to be a sure thing. That’s why you need to go the extra mile to keep the 5 C’s—your capital, character, capacity, collateral and conditions—in check.