The Five C’s Of Credit

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Looking to get a loan for your business? Lenders will judge your creditworthiness before approving you for a loan. You probably know your credit score plays a vital role in deciding your approval odds, but it’s not the only factor involved.

Lenders use the five C’s of credit to get a sense of your repayment capability. Remember: lenders want to make sure you can repay your loan. Whenever you default on your loans, lenders take heavy losses, and your credit history takes a hard hit. A lose-lose situation for everyone.

Primarily, lenders are looking to make sure that your business is stable, trustworthy, and can pay off the monthly payments. They’d rather not give money to those with businesses that aren’t making any revenue or just recently went bankrupt—that would spell disaster for the lenders. 

The five C’s of credit that lenders use to evaluate your creditworthiness are Capacity, Capital, Character, Collateral, and Conditions.

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Capacity

What: Can you meet your monthly debt repayments?

Capacity is one of the key C’s of credit. Lenders will look through your cash flow, income, employment history, stability, and debt-to-income (DTI) ratio to see if you can pay off your debt. 

Why: If lenders feel like you can’t meet your repayment obligations, your lending journey will likely stop here. It won’t matter how good your other 4 C’s are if you can’t display the ability to repay your loan. 

Make sure your DTI ratio is within a reasonable range. The DTI ratio is your monthly liabilities divided by your gross monthly income, representing your ability to make monthly debt repayments. 

For reference, many lenders won’t approve mortgages for applicants with DTIs higher than 42%. Lenders such as Wells Fargo view different ratios to mean various risks:

  • 35% or less: debt is manageable; you’re in a good place
  • 36 – 49%: DTI ratio could improve
  • 50% or more: debt is unmanageable and is taking over 50% of your income; bad!

The main idea here is that the lower your DTI, the more likely you will be approved. 

Capital

What: How much skin do you have in the game?

Lenders want to see that you’re putting something towards your loan. Capital generally refers to the “down payment” (similar to when you buy a house) or other personal assets and investments you have that can pay off the loan. 

Why: The more you have personally and financially invested in your business, the more risk you take on. This distributes the risk evenly, helping to reassure lenders that you are very serious about your project. 

For example, if you’re only willing to put down $1,000 and ask for $100,000, then lenders might question why you’re not confident in your own business. Differently, if you put down $20,000, then lenders will be more inclined to trust you.

Likewise, having personal assets and investments can help lenders feel a little safer about giving you money. Having investments, such as ETFs or individual stocks, that can be used to pay off the loan when you’re having trouble making payments comforts lenders. 

Character

What: What’s your reputation?

Character is basically a way to describe your credit history, credit score, education, experience, and integrity. Lenders want to see that you’re trustworthy based on your past and have a strong reputation in the field. They may even tap into your references or your employee’s experience levels as well. 

Why: Banks want to lend to trustworthy people that seem to possess the ability to repay their loans. For example, if you defaulted on your mortgage, then the lender might be hard-pressed to approve of you. What’s to say you won’t default on this business loan? 

Moreover, knowledge and experience play an enormous role as well. Say you have launched three enormously successful businesses and showcased an exact growth timeline before asking for a loan. That’s a fantastic track record that would make lenders feel a little more secure. 

Furthermore, relationships play a crucial role in these interactions. Being able to showcase your expertise, experience, integrity, and professionalism in your interactions with the lender is extremely important. 

Collateral

What: If you were suddenly unable to pay off your loans, do you have a way to secure the loan with something non-cash? 

For example, when applying for mortgages, your collateral is your house. If you defaulted on your mortgage, the lender would take possession of your home. 

Why: Lenders don’t want to simply give you money without having a way to secure it. A collateral is a fantastic way to reduce the lender’s risk because it gives lenders a way to feel a little safer with their decisions. 

Lenders use the loan-to-value ratio (LTV) to weigh their lending risk. LTV represents the amount you want to borrow relative to the value of your collateral. The lower the LTV, the less risk involved for the lender. 

For instance, if you want a $90,000 loan, and your collateral is worth $100,000, then your LTV is 90%. Comparably, a $50,000 loan would have an LTV of 50%. The lower LTV is favorable for the lender since they can take your collateral and sell it to cover their losses after default.

Conditions

What: How will external economic conditions affect your business? What do you plan on using the money for?

Why: Lenders will want to understand what their funds are being used towards. Being explicit about your intentions and goals is good because it will also build your (3) Character. 

Moreover, maybe your business has a strong competitive advantage breaking into a new market. These are exciting prospects for lenders who will be more inclined to help you out. 

Though, you won’t have any control over the surrounding economic or environmental conditions. During times of economic recession, lenders are hard-pressed to distribute loans due to credit crunches. Furthermore, your business might be in an area susceptible to earthquakes, which could scare lenders a little. 

Consider everything going on around you and see if now is the best time for you to apply for a loan. 

How To Improve The C’s

Capacity: Minimize Your Debt-To-Income Ratio

Your DTI ratio plays a vital role in deciding your Capacity. Consequently, planning ahead to reduce your DTI will help.

Recall that the DTI ratio is just your monthly debt obligations divided by your monthly gross income. Thus, there are two ways to reduce your DTI:

  1. Pay off previous debt to reduce your monthly repayments
  2. Increase your gross monthly income

The first of these two is generally easier for most people. We all wish we could magically boost our monthly income. However, you can plan ahead and pay off as much of your previous debt as possible. Doing so will help decrease DTI. 

Character: Boost Your Credit Score

FICO Score 8

There are several ways to improve your credit score, which will help your Character.

Though, if you’re trying to increase your credit score, you must first thoroughly understand how your credit score works. Make sure you have looked into Credit Karma and Credit Sesame to ensure you can monitor your score’s growth.

Once you’ve done these preliminary steps, then you can start exploring ways to help your credit score.

Check Your Credit Report For Errors

Sometimes the credit bureaus make errors on your credit report. In fact, the Federal Trade Commission estimates about 20% of consumers have mistakes in their credit scores. This is a stark stat considering how many people are likely affected.

Unfortunately, it takes months to fix errors. 

Thus, if you plan on applying for a loan, make sure to examine your credit at least six to nine months beforehand. This timeframe will give you plenty of time to file a dispute. 

Pay Off Your Credit Cards

Credit card utilization factors into 35% of your FICO score. This ratio represents your credit use divided by your total credit limit. 

The lower your credit utilization, the higher your credit score.

The nice thing about this ratio is that it resets frequently. Therefore, you can minimize your utilization before using your credit score.

One to three months before applying, pay off all your credit cards weekly. This move will place your utilization ratio near 0% when your card companies report your utilization to the credit bureaus.

A 0% utilization ratio makes the FICO and VantageScore algorithms happy.

Ask For Credit Limit Increases

Remember that your credit utilization comprises 35% of your credit score. 

By getting a credit limit increase, you’ll effectively decrease your credit utilization ratio. Sorry for sounding like a broken record, but the lower your ratio, the higher your credit score.

All you need to do is talk to your credit card issuer and see if they’d be willing to bump up your limit. This usually only happens if you’ve demonstrated strong repayment history and are generally qualified. 

It also doesn’t hurt to ask. The worse they can say is no, and that limit boost could help bump your credit score. 

Open A Credit Card With Good Habits

Opening another credit card on your history can be helpful. If you maintain excellent habits, you’re set to rake in credit score boosts.

Firstly, your credit utilization ratio will decrease. This new card will increase your total credit limit, which will lower your ratio. 

Next, if you maintain a good repayment history, then the “payment history” portion of your credit score will also improve.

Finally, adding a credit card could improve your credit mix, which plays a small role in your score.

However, simultaneously opening too many credit cards could harm your credit score. When you apply for a credit card, the lender will do a “hard inquiry” on your credit report, which will temporarily ding your score for up to 24 months.

Getting a new card will affect your credit score after a few weeks, but positive effects increase as time goes on. Note that everything we’ve just noted also applies to secured credit cards.

Check out Fundera if you want to apply for a business loan. Their service makes it super easy.

Frequently Asked Questions (FAQ)

What are the 5 C’s of credit?

The five C’s of credit that lenders use to evaluate your creditworthiness are Capacity, Capital, Character, Collateral, and Conditions.

Are there only 5 C’s?

Although the 5 C’s described in this article are a pretty general baseline, there are arguably some other “C’s.” For example, Communication is also crucial to establishing strong Character. Being able to respond to emails and other messages promptly showcases your dedication and efforts. 

Others have noted that Courage is also one. Having a strong ability to lead a team with a clear vision and directive is worthwhile, and can show lenders you have the potential. 

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