When financing small businesses, lenders evaluate the borrower’s ability to repay loans before deciding whether or not to finance them. If you want to increase your chances of securing business funding, you should understand the 5 C’s of credit. Regardless of whether you are borrowing from a bank or individual, prospective lenders evaluate your creditworthiness to avoid the risk of default.
Although guessing might pay off if you are lucky, it is useful to understand the lender’s magic metric. There is a consistent lending framework that lenders use to gauge if the borrowers have the ability to pay back the loan. The framework is called the 5 C’s of credit. It includes character, capital, capacity, collateral, and conditions.
How Lenders use the 5 C’s of Credit
Lenders use the same metric to judge their borrowers, and each component has different measurements across lenders. One lender may focus on the collateral, while the other may focus on the capital. They may ask questions like: Will they pay back? Will the money be used the right way? What is their credit history?
Banks use the 5 C’s of credit when giving business credit. However, the metrics also apply to other types of credit like student loans, car loans, and asset financing. By knowing what lenders want in a client, you will easily get the loan approved.
The following are the 5 C’s of Credit:
The first “C” represents capacity and it is one of the most important metrics. It measures the borrower’s ability to repay the loan in full and on time. Lenders compare the borrower’s income against the recurring debts. They also assess the borrower’s debt-to-income ratio. The lower the ratio, the more debt you can afford. In the loan application form, you should reveal all revenues, expenses and cash flows.
The lender will also evaluate your past repayment history, both in employment and in business. Previous credit payments are considered as indicators of future loan repayments. You should indicate your repayments in the application form. Lenders want to give money to people who can repay the money plus interest. If they lend money to individuals with a bad credit history, they risk losing their money.
The character of a borrower is a subjective judgment that lenders make to determine if the client is trustworthy. Ideally, the lender wants to know if you are a responsible and reliable person. Will you pay? Can a lender trust you to repay the loan in full? What is your history with lenders?
Borrowers with a good character are more likely to repay the loan on time. On the contrary, borrowers who are irresponsible are likely to default payments. Lenders want to avoid giving loans and then spending a lot of time and money to recoup payments. They analyze the borrower’s credit scores, both in business and person. The higher the credit score, the more reliable you are and the higher chances of getting a loan. The credit reports may also reveal your open credit lines, credit utilization and time of repayment.
Apart from the credit history, lenders will also evaluate your character, references, and how you talk to people. As a rule, you should be polite, prompt and organized when talking to your lender. Your behavior might be the deciding factor if you are going to get credit.
Before applying for credit, you should have invested significantly in the business. A lender would prefer lending to borrowers who have invested their money in the business. For example, lenders would find it easier giving you a mortgage if have paid a down payment for the home. A down payment indicates your level of seriousness in the investment. Also, this decreases the borrower’s chances of default.
Capital is a major component of the 5 C’s of credit. It shows your level of dedication in the business. Plus, if you are not investing in your yourself, why should a lender invest in you? A bank measures capital by looking at the value of your investments in the business. The more assets and money you have invested, the less risky it is for a lender to invest in the business.
Conditions refer to how the borrower plans to use the funds given by a bank. Will the money be used to purchase inventory, vehicle, home or working capital? A lender is likely to approve a loan for a specific purpose than a loan that could be used for anything. You should disclose the intended purpose of the loan in the loan application form. If you fail to indicate the purpose of the loan, the loan processing time may take longer. The bank may also decide to cancel the loan application form.
Also, the lender will consider inflation, industry trends and other factors that could affect your business. These conditions may affect your ability to service the debt. Lenders want to minimize risks by loaning money during favorable conditions. While you many not have control over these factors, you should demonstrate that you are in control of the environment.
A collateral assures the lenders that, if the borrower defaults, the lender can repossess the collateral. The collateral may be an equipment, inventory, a home or other types of collateral accepted by lenders. It may also include a guarantee from a third party. A guarantor assures the bank that, in case you default on the loan, they will pay the lender. Some lenders may require both collateral and guarantee as security for the loan. Lenders determine if the value of the assets corresponds to the amount of the loan.
By asking for collateral, lenders want assurance that they will not lose all their money. If you default on the loan, they can sell the items declared as collateral to recover their cash. Where the lender auctions the main business assets, the business will be at risk of closing down. The fear of losing assets will motivate borrowers to make timely payments to the lender.
The 5 C’s of credit are the magic metrics that lenders use to evaluate the borrower’s ability to repay back the loan. The weighted value of each component varies from one lender to another. Knowing what lenders are looking for will help you craft a better loan application. If you convince the lender why need the loan, it will be easier to secure financing.
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