Credit Analysis: The 5 C’s of Credit
The 5 C’s of credit or the five characteristics of credit is a system that many lenders use for credit analysis. Lenders use this framework to determine whether they will provide loans or credit to a potential borrower.
Lenders will only provide credit to borrowers when they know they can get their money back. The goal of credit analysis is to reduce the risk of loan default. The more confident a lender is in the applicant’s ability to pay back the loan, the greater the chance the lender will loan out the money.
The five C’s of credit helps lenders judge the likelihood that borrowers will default on their loans.
Different lenders will assign different scores to each of the 5 C’s of credit and use different metrics for credit analysis. Some lenders may care about a borrower’s credit score more, while others pay more attention to the applicant’s income.
The five C’s of credit that most lenders use to decide whether they will provide the loan are character, capacity, capital, collateral, and conditions.
These characteristics provide a general framework for lenders to gauge the risk involved with the loan before they fund the loan.
Character
Character in credit analysis is the lender’s opinion on your creditworthiness and reliability.
The lender is trying to see how likely it is to get their money back. They are trying to make a case that you are reliable and will return the borrowed money.
If a borrower has a history of taking loans and making payments on time, the lender can be assured that there is a good chance that the borrower will make good on their loan too.
Instead, if a borrower tends to be late in making payments or in the past has been unable to pay back the loan, a lender will be wary and may turn the borrower away.
Different lenders judge character using different metrics. When it comes to personal loans, lenders often use credit history and work experience, and references.
When putting together a credit analysis for business loans, the lender might use other metrics, like trade references and the business’s credit history both with the lender and with others.
The lender uses these to form their own opinion on how reliable you might be when you take out the loan. The lender’s goal is to reduce the risk that they will not be paid.
Capacity
Capacity is an important metric for lenders in credit analysis. Capacity refers to the amount of cash flow the borrower generates and whether it will be enough to pay back the loan.
Borrowers may have the intention and even the history of paying back their loans. However, they may not be able to because of their current financial situation. Lenders want to lend to people who intend to pay back their loan and can pay it back based on their current financial situation.
Typically, lenders use different metrics to evaluate a borrower’s income and compare it to other obligations. The additional obligations can affect the borrower’s capacity to pay back the loans.
For personal loans, lenders typically use a metric called debt to income ratio. They will look at your current income (cash coming in) regarding other debt that you might have to determine if you would be able to pay back the loan and fulfill your other obligations.
For businesses, lenders might look at financial statements to see if the company generates enough cash on an ongoing basis to pay back this new loan.
Capital
Capital refers to how much money the borrower has and how much they have invested into the loan.
More money or other assets can provide the lender comfort in the borrower’s ability to repay the loan.
Typically for business loans, lenders will want to extend credit to borrowers who have invested their own money into the venture. This shows lenders that the borrower has “skin in the game.” It shows that the borrower also believes in the venture.
Collateral
The fourth C of credit is collateral. Collateral is any security that the applicant puts towards the loan. Loans with collateral are known as secured loans.
The security guarantees that the lender will get paid back because the lender can potentially sell the collateral to recover the loan. A mortgage is a type of secured loan because the house (or other real estate) serves as the collateral for the loan. If the borrower cannot pay back the loan, the bank can seize the house and sell it to get their money back.
When there is collateral involved, the lender may even want to appraise the collateral to make sure that the value of the collateral is enough (or more) than the value of the loan.
Conditions
The last C of credit is conditions. Conditions are both related to conditions that the borrower can control and those out of the borrower’s control.
Lenders might consider loans made for a specific purpose, like a business or purchase, more favorable than a general loan. The amount of the loan and the interest rate may even be a factor in their lender’s decision to make the loans.
Conditions like the overall economy are out of a borrower’s control. When there is an economic downturn or higher interest rates, borrowers might find it harder to get loans because lenders are not confident that all borrowers will pay them back.
The 5 C’s of Credit for Credit Analysis
The 5 C’s of Credit is a well-known system many lenders use for credit analysis to determine if they will loan their money to a potential borrower. Although there is never a guarantee that the borrower will pay all their loans, lenders are trying to reduce the risk of default.
If you’re in the market for a new loan, understanding the 5 C’s of credit can help you build a better case for your lender. The better you score in the lender’s credit analysis, the more like they are to provide you the loan you request.