The 5 C's Of Credit - Guide To What Lenders Look In A Loan Application

Getting immediate financial support in times of emergencies is not convenient always. In such situations, a Personal Loan can be a great help. But getting loans approved by financial institutions is also not a cakewalk. However, there are ways to ease this process. You can do so by assessing your financial situation from the perspective of the lender and then figure out whether you are credit ready or not. Lenders tend to evaluate your loan application based on the 5 Cs of credit.

What are the 5’C of credit

In any sport, it is important to both envisage and evaluate what the opposition is trying to do to win the game. Similarly, in the field of loans, it is important to see things from the perspective of the lender and understand their requirements to maximize the chances of securing a loan of the desired amount. Luckily, one does not need to rack his/her brain too much as there are a few set parameters on which lenders judge the borrower’s creditworthiness and ability to repay a loan. This system is called the 5 Cs of credit - Character, Capacity, Capital, Conditions, and Collateral.

How to master the five C’s of Credit

1. Character

What is character

The lenders are less interested in your moral character and more on your financial character, i.e. to see what kind of trustworthy borrower you have been and your reputation as a businessman. Lenders trust responsible and organized businesses that are more likely to make the repayments on time.

How it is assessed

Character is analyzed by thorough checking of your credit reports and credit scores of both your business and personal credits, your market reputation of running a stable firm and verification via references.

Ways to master it

First, raise your credit score before applying for loans by repaying your old debts. Stay professional while dealing with lenders and leave a lasting impression with your knowledge of the business and experience in the field. Try to build a personal rapport with the lenders.

2. Capacity

What is capacity

Capacity means evaluating a person’s ability to repay the loan and is calculated in terms of cash flow, i.e. the cycle of income and expenditure. Capacity matters for lenders as they check how much profits you have been making lately and if your financial health is good enough to afford a loan and repay it without delays or defaults.

How it is assessed

It is analyzed by checking cash flow statements and projections, bank statements, debt service coverage ratio (DSCR), and debt-to-income ratio (DTI). All these documents tell the lenders about the cash flow in the business at present and how it will be shaping up in the near future. DSCR and DTI ratios establish how much money is being spent on paying business and personal loans, respectively.

Ways to master it

Increase the income and lower the expenses. Use accounting software to get the cash flow statements and projections. Improve your DSCR and lower your DTI as more cash invested in the business is seen as a good sign, but more personal loans are seen as an additional burden.

3. Capital

What is capital

Capital is money you have already invested in your business and the amount of money you are seeking to invest.

How it is assessed

Larger the sum you have invested in the business, the bigger is the possibility of getting the loan. It establishes your intent of making the business grow and such a person is likely to repay the loan. Lenders also check what kind of investments you have made and what dividends have been paid.

Ways to master it

Invest money in the business and earn some profits out of it before applying for loans. Keep a blueprint ready explaining how you will be using the loan money to increase the profits and thus, repay the loan on or before the deadline.

4. Conditions

What are conditions

Simply put, conditions are the terms and conditions levied on the loan and how they might be changed vis-à-vis any changes in the economy. It is a measure taken by lenders to minimize the chances of losing money.

How it is assessed

Lenders put conditions on the use of the loan and the interest rates. They check industry risks, competitors in the market etc. Some industries are so risk-heavy that lenders do not entertain their requests.

Ways to master it

Explain where you will invest the money – inventory, staff, investments, and collaborations – to up your returns. Always apply for a loan when the cash flow is good and business is booming to get better terms and conditions. Getting loans will be difficult when your business or the whole economy is going through a rough patch.

5. Collateral

What is collateral

These are assets like home, jewelry, car, and other valuables that can be pledged as security. A collateral makes the loan a secured loan as financial institutions can seize and sell them in case of defaults.

How it is assessed

Some lenders settle for specific collaterals like a property or home, but some want a blanket lien or a personal guarantee.

Ways to master it

Evaluate your assets’ market price and the depreciation rate. Be careful about what you are willing to put on stake and find a lender who gives loans on favorable terms.

When it comes to loan applications, knowing what lenders want is a bonus. Using the 5 Cs of Credit, you can evaluate your chances of getting a loan and improve on any of the departments where you are lacking. One cannot score a ten on ten on every C but make sure you have excellent ratings in some and are at least above average in the others. In the end, it is aimed at establishing yourself as a credible borrower in front of the lender.

Importance of the 5 C's of Credit

When you apply for a loan, the lender wants to ensure you can repay the borrowed amount on time. They check your creditworthiness to evaluate your repayment capacity. The 5 Cs of credit are important in the credit field because loan providers use them as determinants to approve financial products. Lending institutions also use these 5 Cs of lending to set your loan amounts, interest rates, and repayment terms. These are:

1. Character: Your credit history
2. Capacity: Your capacity, based on your debt-to-income ratio
3. Capital: The amount of money you have as a financial backup
4. Collateral: An asset you provide to pledge as a security against the loan
5. Conditions: The loan purpose, the amount involved, and current interest rates

Loan companies use these parameters to gauge your creditworthiness when you apply for a loan. They weigh these five characteristics to estimate your lending risk and chances of default, meaning the lender's risk of loss.

Since these 5 Cs of credit are so important, understanding them can boost your credibility and help you grab credit with favorable terms and conditions. Here’s everything you need to know.

Uses of the 5Cs of Credit by Banks and Lenders

It’s important to learn how banks and lenders use these to boost your chances of approval when you apply for a loan.

When you use credit, you develop a credit history that lenders use to evaluate how responsibly you have handled credit in the past, how much you have borrowed, and whether you repaid them on time. They consider missed EMIs, bankruptcies, and foreclosures red flags while evaluating your loan application. Regarding capacity, lenders check your existing debt and compare it with your income to assess your DTI ratio. A low DTI ratio indicates less risk, indicating a high repayment capacity for new loans.

Besides these, loan providers check your savings, assets, and investments to evaluate your repayment capacity even after a job loss or another unexpected situation. Moreover, they demand collateral for secured loans, which they can seize and sell to recoup their outstanding balance if they fail to repay your loan. Conditions include other details lenders use to determine your credit eligibility, including your loan purpose, market conditions, industry trends, repo rates, etc. So, keep these 5 C’s of lending in check before applying for a loan.

How Can You Improve in Every Five Cs of Credit?

Now that you know the five cs of credit and understand how important they are to your online Business Loan application, below you will learn how to improve them to grab the loan offer you deserve:

1. Character: Ensure that your credit history is error-free on your credit report. Implement automatic payments to ensure timely repayments and build a decent CIBIL score to improve credibility.
2. Capacity: Increase your salary, decrease debt, and avoid changing jobs to showcase financial stability. Remember to include additional income sources, like earnings from your freelance or part-time work, investments, etc., to showcase a higher capacity.
3. Capital: Building capital takes time, but investing money in the right places and timing your major purchases appropriately will help.
4. Collateral: While unsecured loans do not require collateral, provide one for a secured loan according to the loan amount you demand. Build assets to pledge as collateral and pay your EMIs on time to safeguard them against foreclosure.
5. Conditions: Although social, political, global, and macroeconomic conditions are beyond your control, evaluate your loan requirement and current financial position before applying for a loan. Avoid borrowing when the conditions are unfavourable.

Conclusion

These are the 5cs of credit examples you must consider while applying for an online Business Loan or another type of credit. Perform a 5cs of credit analysis and see where you stand. After this analysis, if you decide it is not the right time to borrow, find other funding sources to meet your requirement and concentrate on improving the five c’s of credit.

Frequently Asked Questions

1. What is the 6th C of credit?

The 6th C of credit is Credit Score, which you earn based on your repayment history, diversity in the credit portfolio, credit age, and overall credit-related behaviour.

2. What are the 7Cs of credit?

The 7 cs of credit are collateral, capacity, credit, character, conditions, credit score, and cash flow.

3. Are the 5 C's of Credit the same for all types of loans?

While the 5 C's of Credit are fundamental principles used across various types of loans, specific criteria and weightings may vary depending on the type of loan and the lender's policies. For example, mortgage lenders may place greater emphasis on collateral (such as the value of the property) than credit card issuers.

4. Can borrowers prioritize one of the 5 C's over others?

Borrowers can't disregard any of the 5 C's, but strengthening one aspect may compensate for weaknesses in another. For instance, a substantial down payment (Capital) might offset a lower credit score (Character).