Understanding the Five Cs of Credit Has Never Been More Important

Interest rates could stay high into next year, if not longer, which means bankers will increasingly adhere to the five Cs of credit when making loans. Here’s what borrowers should know: 

Lenders gauge a prospective customer’s creditworthiness by their character, capacity, capital, collateral and conditions. Those measures will determine whether you get a loan, at what price and under what terms.

Character typically refers to a borrower’s credit history but also includes a person’s reputation. For individuals, credit history can be accessed via credit reports (Equifax, Experian, TransUnion) detailing a person’s available credit, actual debt, payment history and a summarizing FICO score ranging from 300 to 850. If a borrower’s history is unfavorable, it is important to explain changes that have occurred that show why it would be different in the future. And regardless of credit report data and potential firm revenue, a lender usually asks: “Do we want to take the risk associated with this person/entity?”

Capacity measures a borrower’s ability to repay a loan by comparing income against debt-repayment obligations. For individual borrowers, capacity is usually assessed via a debt-to-income (DTI) ratio; for corporate borrowers, useful metrics include a debt service coverage ratio (DSCR) and cash flow leverage. Every lender is different, but for individuals trying to qualify for a mortgage, most lenders want a borrower’s DTI no higher than 40%-45%. For corporate borrowers, lenders generally prefer a DSCR of at least 1.20x but might accept a lower threshold depending on stability/predictability of the borrower’s earnings, the value of collateral or other factors. Business cash-flow leverage measures total or senior debt against cash flow, which is usually defined as EBITDA, or earnings before interest, taxes, depreciation, and amortization, which is a proxy for sustainable cash flow from operations.

Capital refers to funds that a borrower invests, or has available to invest, alongside the lender. One example is the down payment on a home purchase. It also refers to other sources of funds to which the borrower has access, which can be especially helpful if the business plan or project ultimately requires more funds than initially expected. Lenders assess not only the amount of funds potentially available but also whether those funds will still be available if/when they are needed.

Collateral can help a borrower secure a loan by providing the lender with an alternative source of repayment. A house, car, boat, real estate, machinery and equipment, accounts receivable, cash—even intellectual property—are all forms of collateral that can secure a loan. The collateral is often the object for which the loan is obtained. Lenders consider not just the value of the collateral at the time the loan is provided, but what the value will be if the lender takes possession of the collateral to sell it and pay off the loan, and what expenses will be incurred by the lender in that process. Remember that only cash can pay off a loan.

Conditions refers to both the terms of the loan as well as the intended use of the loan. Terms include the interest rate, repayment schedule, any required collateral, any reporting requirements of the borrower (financial statements, etc.), financial or other covenants, and default remedies. Lenders also want to be sure that the loan will be used for a purpose that makes sense given the current economic environment and the borrower’s knowledge and area of expertise related to the intended use of the loan. For example, a loan to build a house to be sold (rather than occupied by the borrower) may not make sense in a slumping market for residential housing.

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