Ever wonder how a bank evaluates your loan application. David Ceolin, author of The Idea Guide is a former loan officer who evaluated business applications for loans. Here is a quick summary of the “5’Cs of Credit”, five words that start with the letter C and denote how a bank evaluates a loan.
When an individual or a business applies for a loan (called "credit" in the banking world), there are a number of things that a lender will consider before deciding whether or not to approve the request. The lender will typically follow what is called the Five Cs of Credit: Character, Capacity, Capital, Collateral, and Conditions. Examining each of these things helps the lender determine the level of risk associated with providing the borrower with the requested funds. Read more on the breakdown of each C below:
1. Character – Character is reflected in the banking consumer's level of responsibility and willingness to meet their obligations. In a lending scenario, your character is strongly weighted by your credit report. Your credit report is a detailed report outlining your credit history, including any loans you have had, credit cards, and more. The report shows how you have handled credit in the past and gives an indication of how you will handle it in the future. It is also used to generate your credit score, which gives lenders a quick look at your financial habits.
2. Capacity
Banks and other lenders consider your income sources and debt ratios as measures of your ability to repay loans. Are your income and cash flow projections underpinned by believable assumptions to demonstrate that they are achievable? Keep in mind, the bank will be relying on your business's ability to repay loans. Another factor is how much debt the business already possesses. Banks use debt/service ratios to determine if the business generates enough profit and cash flow to handle its current and proposed debt obligations.
3. Capital
Banks are like investors in your business. Investors like to see how much capital you and your family have put in the business before they are asked to invest. Banks similarly look to see what capital you personally have invested in your business as a measure of your confidence in the enterprise. For an annoying business, banks will look to see how much of your profits are reinvested in the business as a sign that you are continually improving the business for future success.
4. Conditions
Another factor is the conditions of your loan. These include the purpose of the loan, the amount of the loan, the applicable Interest rate, the amount of term to repayment, how the loan can be advanced if it is a credit line. Think of the conditions as the guardrails of how the bank will administrate the loan. An example condition might be the maximum amount of a credit line that a business can access on a certain day is based on 75% of the amount of accounts receivable the business has at that particular time. This ensures the bank that sales are occurring and cash coming in.
5. Collateral
A common misconception is that collateral alone should be good enough to support any loan request. However, collateral in the form of assets such as equipment, vehicles, inventory, and buildings loses much of its value in the event that a bank must seize the items and try to sell them. This is why bankruptcy sales and auctions have such good selling prices. Therefore, collateral is usually inadequate to cover the loan amount. In addition, the time, expense, and administration in seizing assets creates reliance on collateral alone not worth the trouble. This is why collateral is looked at last after all of the other C’s.
In summary, banks rely on a number of variables that begin with C in priority order: character of the business owner; capacity for repayment; demonstrated capital invested in the business; and loan repayment or advancement conditions. To shore up these four variables, collateral would be considered as the final step. However, collateral alone will not usually suffice to support a loan application.