For a small business owner, buying a property or securing long-term credit can feel like an insurmountable task. After all, there are many steps that applicants need to consider before being approved for funding.
When underwriters and creditors consider your loan or credit application, they take several factors into account. For the uninitiated entrepreneur, this is enough to scare them away to seek capital financing elsewhere. To provide you with the knowledge you need, we’ve put together a quick guide to the five C’s of credit.
By mastering the five C’s of credit, you can learn the five most important considerations that lenders have when evaluating your loan application. In other words, learning the five C’s can help you secure the funding your business needs to reach your goals. Below, we’ve broken down each of these elements to help you get a competitive edge on the competition.
What Are the 5 C’s of Credit?
Lenders analyze five main factors when you apply for business credit. Known in the industry as “the five C’s of credit,” these considerations are applied whenever a creditor decides whether issuing you a loan passes an acceptable risk threshold.
Below, we’ve listed the five C’s of credit analysis that determines eligibility for business credit. Ensure that you carefully read and understand each before you proceed with a loan or credit application.
A basic capital credit definition would suggest that your Capital, one of the five c’s of credit, is simply your net worth. In other words, your total assets minus liabilities. However, in truth, it’s a little more complicated than that.
When it comes to financing, capital, in this sense, refers to the capital 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 since the more money you have to secure it, the greater your chances of approval.
In short, collateral is the applicant’s pledge of assets or capital that helps secure a loan. Putting up collateral, therefore, gives the lender peace of mind regarding whether their side of the deal is safe. If you happen to default on the loan or fail to make interest payments on the credit line, then your collateral may be taken by the lender.
When loans are backed by collateral, they are often referred to as “secured loans,” which can either be secured by the business or an individual through a personal guarantee. If you lack an impressive credit history, it may be in your best interest to set aside a nest egg to offer as collateral. This way, the lender will assume less risk when lending to you.
One of the main benefits of a secured loan is that they are 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.
While there is no succinct capital credit definition, it’s easy to understand the intangible importance of one’s character when applying for a loan.
Think about it—would you rather lend to a shady business with a poor FICO score, lackluster customer testimonials and a less-than-savory LexisNexis RiskView report? Or, would you rather lend to a transparent company, positively reviewed by customers and the media, with impressive scores from risk analysts and credit bureaus?
Most lenders side with the latter. This is because credit history, reviews and general business practices are always held under a microscope when applying for a loan or line of credit. Any borrower can pull up a company’s credit report compiled by any of the big three credit bureaus (TransUnion, Experian and Equifax). Therefore, it’s critical that you do everything you can to maintain a positive standing with these companies.
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 nine months
- Collections and liens over the last seven years
- On-time payment history
The fourth aspect, Conditions, sometimes has a tricky way of eluding us. This is because “conditions” as a wholesale term can mean so many things that it can get a bit bogged down in technical jargon and obscurities.
However, for simplicity’s sake, you can think of conditions as referring to the principal amount, interest rate and the repayment length.
There are several other conditions that can make a lender reconsider lending to you. For instance, it is common for creditors to shy away from applicants with little to no credit history who insist on taking on an unsecured loan. Therefore, those with minimal credit history should always put away a reserve fund to secure any loan they get approved for.
As with any loan, the interest rate should be of paramount importance when it comes to small business lending. For business credit cards, interest rates can run over 50% on purchases, while large national banks typically charge an average annual interest rate (AIR) of roughly 2.5%-5% for lines of credit or 5%-7% for SBA loans.
The old maxim of “Know Thyself” can even prove useful when applying for a business loan. Knowing the answer to what are the five c’s of credit begins with understanding one’s capacity to repay it. Therefore, any business line of credit applicant needs to take an honest look in the mirror before signing the dotted line.
First, discover 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 convenient figure to determine how easily you can pay off additional debts.
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 will want yours to be under 35% to be in the running for most loans. To find your DTI ratio, check your balance sheet and plug your business’s financial information into the following formula:
Debt-to-income ratio = recurring monthly liabilities / gross monthly income
The Five C’s at a Glance
Running a business requires the use of both the quantitative and qualitative minds. Funding a business is, believe it or not, much the same way. Whenever you file an application to secure credit for your small business, creditors take a holistic approach to determining your creditworthiness.
In other words, lenders want to know the numbers—such as your DTI ratio, FICO score, gross revenues and so forth—as well as the intangible figures like reputation, credit history and flexibility. This is what the five C’s of credit encapsulates: a holistic profile of your company’s creditworthiness.
Why Do the 5 C’s Matter?
It should be a surprise to no one that lenders always want to minimize risk. This is true of mortgage lenders as well as small business creditors. No matter what, the lower the risk to the lender, the more likely 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 five C’s. 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.
Ultimately, creditors don’t have to feel like they are gambling on your business. Instead, they want their investment to be a sure thing. That’s why you need to go the extra mile to keep your capital, character, capacity, collateral and conditions in check.
Capitalizing on Credit
Knowing the five C’s of credit will only get you so far. To maximize your chances of getting approved for a business loan, mortgage or business line of credit, you need to do the nitty-gritty work that other businesses shy away from, such as improving your DTI ratio and regularly saving to secure your loans.
As your business grows, your reputation in the eyes of lenders and creditors should improve. That is, as long as you remain mindful of the five C’s and all that they can do for boosting your business’s credibility.