Have you ever wondered what criteria lenders use to determine whether they should extend credit to you or your business? The 5 Cs of credit help lenders to come to a decision as to whether to lend you money or not. These are Character, Capacity, Collateral, Capital, and Conditions. You can use these to evaluate yourself and know which areas might stand in the way of you getting a loan.
Character speaks of your trustworthiness. The quickest way for someone to trust you is if they find out who else has trusted you. They immediately consider your credentials. This may speak of your position in your company and how long you’ve held that position of trust. Your reputation in the community, whether social or business community goes to show how others have trusted or not trusted you. Your relationship with other creditors will tell whether you are worth new credit. This is where the credit bureaus come in to see if you are black listed or not. When borrowing for your business, the track record of the company is required to determine its character, and this is reflected in the company financial statements.
The next C is Capacity. The most direct measure of capacity is your debt to income ratio. This is the percentage of your income that goes towards servicing debt. The higher the debt to income ratio, the more like you are to get a decline for a loan since this is perceived as high risk. Different lenders have different criteria from low, to medium, to high debt ratio requirement. If your debt to income ratio is low, you may get favourable terms. Your loan might cost you more if you are in the upper medium to high debt ratio, that is, if you are given a loan.
Collateral is the next C that almost everyone knows about. This is when the lender asks you to pledge an asset that they could repossess in the even of you failing to repay the loan. Lenders often require collateral for large amounts of new credit. A business borrowing large amounts may be required to pledge is equipment, inventory, or invoices as collateral. People with a poor credit history will also be required to provide collateral for their loans. This may be a house, a car, or other paper assets such as life insurance policies, or other investments.
Capital speaks of your net worth. Your total assets minus your liabilities gives your net worth. Obviously if your liabilities exceed your assets, you have negative capital and are therefore not worth the risk. Individuals and businesses should make sure that as the years are ticking on, they are adding more assets in their lives to make sure that their net worth is growing. It doesn’t help to work for so many years and still have nothing to show for it. This will obviously work against you if you should need credit.