The 5 C’s of Credit – Ultimate Borrower’s Guide

 July 22, 2019

Short Summary of the 5 C’s of Credit

Are you interested in getting a loan to finance the purchase or construction of commercial real estate? Then you’ll need to understand the 5 C’s of credit. Indeed, they are equally important for all types of loans, both business and personal. In this article, we’ll define “What are the 5 C’s of credit?” We’ll also describe their relative importance and identify resources that provide the 5 C’s of credit analysis. Finally, we’ll review personal vs business credit scores and answer some frequently asked questions about credit-worthiness.

In addition, you can read How to Raise Your Credit Score in 30 Days – 20 Smart Ideas if you’re interested in giving your credit score a quick boost.

Video: The 5 C’s of Credit Explained

What Are the 5 C’s of Credit?

The five c’s of credit in alphabetical order are capacity, capital, character, collateral, and conditions. Lenders use the 5 C’s of credit to assess a borrower’s credit-worthiness when underwriting a loan. Clearly, a lender wants reassurance that it will receive repayment of the money it lends. Therefore, you improve your chances for loan approval by scoring well in each of these five categories.

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Five C’s of Credit: Capacity

Capacity is your ability to repay the money you owe, on time and in full. Initially, a lender evaluates capacity by examining your cash flows and current assets. Then, the lender assesses your recurring debts and your debt-to-income ratio (DTI). Specifically, you calculate DTI by dividing your gross monthly income into your total monthly debt payments. Obviously, your chances of loan approval increase as your DTI drops.

Naturally, each lender has its own DTI criteria, but 35% to 43% tends to be the acceptable maximum. Moreover, some may require that you generate $1.25 in income for every $1.00 that you must pay in debt service. Also, lenders want to know that there is enough cash after debt service to pay the owner’s salary. Otherwise, they may fear that the owner might be less motivated to keep the company operating. Some complicating factors include a short operational history, industry change, and volatile cash flows. Naturally, you can improve your credit capacity by paying down past debt, increasing revenues and reducing your operating expenses.

Five C’s of Credit: Capital

Capital refers to your equity in your business and what is available for a down payment on your loan. Clearly, the more equity you can put down, the less leverage you require on the loan. Lenders do not favor high-leverage loans, as these have the highest default risk. Typically, depending on the loan type and source, you will need to put down 20% to 40% of the purchase price. However, certain loans may require a substantially smaller capital injection. In addition, lenders look at the overall capital structure of your business. That is, they want to see how much money you’ve contributed to the company — your skin in the game so to speak. They also want to evaluate your retained earnings and other assets you control.

Unsurprisingly, lenders might get nervous if they see that your business lacks equity capital by being top-heavy with debt. On the other hand, if you make a large down payment, you may receive better loan terms and rates. Ultimately, lenders consider capital a backstop should your cash flows falter. Naturally, you can improve loan approval chances by increasing your capital contribution. Also, it is wise to highlight any previous successes you’ve had deploying your capital for profitable investments.

A graphic explaining the 5 most important factors to creditworthiness

Five C’s of Credit: Character

Just what kind of person are you? For example, do you take your financial obligations seriously and repay your loans on time? Commonly, lenders investigate these questions by analyzing your credit history and credit scores. That is, they reference the credit reports from Experian, TransUnion, Equifax, Dun & Bradstreet, and other credit bureaus. Obviously, they will look for character flaws (credit derogatories), such as bankruptcies, collections, foreclosures, court judgements and tax liens. Without a doubt, any of these factors cast a poor light on your credit-worthiness.

Conversely, it is favorable if you demonstrate that you’ve handled your debt obligations responsibly. Therefore, lenders will examine your references, credentials, previous interactions with lenders, and your overall reputation. However, be aware that some CRE lenders and loan types put less emphasis on character. Instead, they may concentrate on the value of the property versus the size of the loan. For example, hard-money lenders may simply ignore your character unless it is truly rotten and includes cases of fraud. For better or worse, lenders may equate a low credit score with poor character. Naturally, you can improve your loan approval chances by raising your credit score.

Five C’s of Credit: Collateral

Lenders want to know the value of the business and personal assets that you pledge as loan collateral. Normally, the property serves as collateral for purchases, rehabs, and refinancings. However, you must provide other collateral when the loan is for new construction. Should you default on your loan, the lender will seize and sell your collateral to recoup its losses. Explicitly, in a recourse loan, the borrower puts a lien on your personal assets, not just your business ones.

Typically, only the best customers have access to non-recourse loans. These are loans in which you don’t pledge personal property as collateral. And of course, unsecured loans do not require collateral. For example, personal loans and most credit cards are unsecured. Clearly. the usefulness of a property as collateral suffers if the property has liens against it. Importantly, if the value of a property is insufficient to cover collateral requirements, you can pledge extra collateral. Note that hard money lenders will consider the improved (rather than current) value of a property as collateral. Of course, they often require 40% equity contributions from borrowers.

Five C’s of Credit: Conditions

Market conditions influence the availability of credit. In fact, lenders must consider the condition of the real estate industry and the country as a whole. Conditions can impact loan terms and rates, the size of the loan, and the required credit score. Notoriously, bank credit dries up when conditions head south. That’s why so many borrowers depend on high-end, private loan brokerage firms like Assets America®. Our network of private lenders, banks and numerous other funding sources will make the best offers available in light of current conditions.

Frequently, lenders seek to know how changes in economic conditions will impact a borrower’s credit-worthiness. For example, if the borrower is building an office tower, a recession would put pressure on potential rental rates. On the other hand, a neighborhood that’s gentrifying might facilitate your ability to finance a new apartment complex. Typically, lenders might examine indicators such as your customer and supplier relationships, the level of competition, and industry-specific factors. Additionally, lenders may monitor Congress to see if any legislative changes could impact the lending environment. To be sure, conditions also refer to the loan terms, such as size and rate. Some loans may come with restrictions on the borrower’s freedom of action.

Which Credit Factors are Most Important?

To say that all 5 c’s of credit are important doesn’t mean they are all equally important. Naturally, opinions differ, but the objective criteria — collateral, capital and capacity — are usually the most important considerations. On the other hand, some banks value character and conditions above all else. In a recession, banks can get very picky about to whom they will lend. Also, banks may more harshly judge character lapses than might other lenders.

Conversely, hard money lenders might downplay character, capacity, conditions and capital, instead concentrating on collateral. Furthermore, the importance of any one factor can fluctuate over time. For instance, conditions can gain primary importance during a recession but then lose sway during a boom. Moreover, when the economy is weak, capital and capacity can have a larger impact on lending decisions. Generally, collateral is key in all market conditions, so it is our candidate for the most important factor.

5 C’s of Credit Analysis

Lenders perform the 5 c’s of credit analysis to decide who will receive a loan and who won’t. Furthermore, among those who receive loans, the 5 c’s of credit analysis help determine how much you can borrow. Moreover, credit analysis will impact your interest rate and other loan terms. Here we offer a couple of examples which should suffice to clarify.

Example 1: Capacity

By and large, lenders measure capacity by reviewing your debt-to-income ratio and cash flows. As we mentioned previously, the lower the DTI ratio, the better. For example, Business-A and Business-B each earn an annual income of $10 million. Now, Business-A owes $2 million in debt, giving it a DTI ratio of 0.2. In contrast, Business-B has $5 million in debt giving it a DTI ratio of 0.5. A lender choosing between the two will pick Business-A, all day long, because Business-A has more cash flow after servicing its debt. Naturally, if further research shows that the owner of Business-A is a repeat felon, all bets are off.

Example 2: Character

Banks might prefer business owners who are pillars of the community. But as this example shows, that won’t necessarily cut it. Consider the Owner of Business-A who is well known in his community for his leadership. Furthermore, he is a deacon of his church and leads charity drives. Normally, you might expect banks to fall all over themselves offering him a loan. Unfortunately, Owner-A has driven two previous businesses into bankruptcy, and they are well-known for suing his lenders. Predictably, his credit score is poor, and no bank feels it can offer him a loan.

Best Software for Credit Analysis

Not all lenders have huge underwriting departments supporting every one of their loan decisions. Fortunately, there are numerous software applications that assess commercial credit risk to help lenders make smarter decisions. Here are a few examples:

  • Abrigo: This software from Sageworks helps lenders accurately calculate ratios to ensure consistent credit analysis. It supports global cash flow analysis and real-time data to drive profitability and increase efficiency.
  • CreditPoint: This is credit risk management software that automates credit scoring and accelerates credit reviews. Features include online credit application, data integration, standardized credit reviews, business intelligence and document management.
  • Fiscal Credit Suite: With more than 30 years’ experience, this software provides full credit analysis capability. For example, it offers statement spreading and analysis, exception and document tracking, scalability, centralized data and powerful automated processes.
  • Zest Finance: This is cutting-edge software that incorporates artificial intelligence to improve loan underwriting. Its machine-learning capabilities offers higher approval rates, lower default rates, and faster model development.

Business vs Personal Credit Scores

Typically, when a business owner seeks a loan, lenders check both the owner’s personal and business credit scores. Often, these two scores are independent because they use different metrics. To be clear, a personal score is a measure of your credit-worthiness as an individual. On the other hand, a business credit score estimates a business’ ability to pay its bills.

Personal Credit Scores

A lender examines your personal credit scores to determine whether to lend to you and if so, how much. Of course, the three national credit bureaus (Equifax, Experian and TransUnion) provide personal credit scores and credit history reports. To be sure, all three use credit scores based on the FICO system. That is, your score ranges from 300 to 850, and derives from:

  1. Payment history
  2. Amounts owed
  3. Length of credit history
  4. Credit mix
  5. New credit

If your personal credit score is too low, you can take steps to improve it. These include:

  • Automating your credit payments so that you never miss a payment
  • Adjusting your due dates to match your pay schedule
  • Utilizing less than 30% of your available credit per credit item
  • Not opening too many accounts too quickly
  • Keeping old accounts open, even if you don’t use them
  • Tracking any changes in your credit reports

Business Credit

Business credit sometimes goes under the name of trade credit or commercial credit. Whatever the case, business credit scores help lenders know whether to offer your business debt financing. Naturally, you want a high business score to obtain the most favorable financing terms. Conversely, a low score might spell curtains for your business. Without a doubt, your suppliers and vendors will check your business credit score before offering you credit. Therefore, you’ll want to consider these recommendations to increase your business credit score:

  • Create credit lines with your suppliers and vendors
  • Pay on time
  • Fund your debt payments from net income
  • Constantly monitor your business credit reports
  • Review your credit arrangements each and every quarter
  • Fix any mistakes on your credit reports

Frequently Asked Questions: The 5 C’s of Credit

Why are the 5 C’s of credit important?

The 5 c’s of credit determine whether you can get financing.  That is, you need to score well on the 5 c’s if you want to borrow money on affordable terms.  Clearly, if your credit factors are weak, you will be at a disadvantage relative to your competitors.

Do the 5 characteristics of credit work differently for CRE commercial lending?

Collateral plays a bigger role in commercial lending.  Obviously, individuals often qualify for unsecured credit, especially through credit cards.  However, CRE lending almost always requires collateral.  That collateral can be the property receiving financing, or other property while new property is under construction. 

What should I look for in a credit card?

Look for the best deal you can get with your credit score.  Frankly, this includes low APRs, high credit limits, generous rewards, extended introductory offers and low annual fees.  Truthfully, if your credit score is low, be happy when you receive approval for an unsecured card.  Unfortunately, if your score is bad, you may have to settle for a secured credit card.

Are there other keys to impress lenders?

Yes, as we explain in our article, 6 Keys to Impress Commercial Lenders, you need to think big but maintain a reasonable amount of leverage.  Furthermore, make sure you have sufficient collateral and that you understand all aspects of the financing.  Moreover, you should be able to withstand relentless due diligence.  Finally, show loyalty to your commercial lending brokerage firm.

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