A:

Financial institutions attempt to mitigate the risk of lending to borrowers by performing a credit analysis on individuals and businesses applying for a new credit account or loan. This process is based on a review of a five key factors that predict the probability of a borrower defaulting on his debt. Called the five Cs of credit, they include capacity, capital, conditions, character and collateral. There is no regulatory standard that requires the use of the five Cs of credit, but the majority of lenders review most of this information prior to allowing a borrower to take on debt.

Lenders measure each of the five Cs of credit differently – some qualitative vs. quantitative, for example – as they do not always lend themselves easily to a numerical calculation. Although each financial institution employs its own variation of the process to determine creditworthiness, most lenders place the greatest amount of weight on a borrower's capacity.

Capacity

Lenders must be sure that the borrower has the ability to repay the loan based on the proposed amount and terms. For business-loan applications, the financial institution reviews the company's past cash flow statements to determine how much income is expected from operations. Individual borrowers provide detailed information about the income they earn as well as the stability of their employment. Capacity is also determined by analyzing the number and amount of debt obligations the borrower currently has outstanding, compared to the amount of income or revenue expected each month.

Most lenders have specific formulas they use to determine whether a borrower's capacity is acceptable. Mortgage companies, for example, use the debt to income ratio, which states a borrower's monthly debt as a percentage of his monthly income. A high debt to income ratio is perceived by lenders as high risk, and it may lead to a decline or altered terms of repayment that cost more over the duration of the loan or credit line.

Capital

Lenders also analyze a borrower's capital level when determining creditworthiness. Capital for a business-loan application consists of personal investment into the firm, retained earnings and other assets controlled by the business owner. For personal-loan applications, capital consists of savings or investment account balances. Lenders view capital as an additional means to repay the debt obligation should income or revenue be interrupted while the loan is still in repayment.

Banks prefer a borrower with a lot of capital, because that means he has some skin in the game. If his own money is involved, it gives a borrower a sense of ownership and provides an added incentive not to default on his loan. Banks measure capital quantitatively as a percentage of the total investment cost.

Conditions

Conditions refer to the terms of the loan itself, as well as any economic conditions that might affect the borrower. Business lenders review conditions such as the strength or weakness of the overall economy and the purpose of the loan. Financing for working capital, equipment or expansion are common reasons listed on business loan applications. While this criterion tends to apply more to corporate applicants, individual borrowers are also analyzed for their need for taking on the debt. Common reasons include home renovations, debt consolidation or financing major purchases.

This factor is the most subjective of the five Cs of credit and is evaluated mostly quantitatively. However, lenders also use certain quantitative measurements such as the loan's interest rate, principal amount and repayment length to assess conditions.

Character

Character refers to a borrower's reputation or record vis-à-vis financial matters. The old adage that past behavior is the best predictor of future behavior is one that lenders devoutly subscribe to. Each has its own formula or approach for determining a borrower's character, honesty and reliability, but this assessment typically includes both qualitative and quantitative methods.

The more subjective ones include analyzing the debtor's educational background and employment history; calling personal or business references; and conducting a personal interview with the borrower. More objective methods include reviewing the applicant's credit history or score, which credit reporting agencies standardize to a common scale. (See also "What Is the Difference Between the Five Cs of Credit and Credit Rating?")

Although each of these factors plays a role in determining the borrower's character, lenders place more weight on the last two. If a borrower has not managed past debt repayment well or has a previous bankruptcy, his character is deemed less acceptable than a borrower with a clean credit history.

Collateral

Personal assets pledged by a borrower as security for a loan are known as collateral. Business borrowers may use equipment or accounts receivable to secure a loan, while individual debtors often pledge savings, a vehicle or a home as collateral. Applications for a secured loan are looked upon more favorably than those for an unsecured loan, because the lender can collect the asset should the borrower stop making loan payments. Banks measure collateral quantitatively by its value and qualitatively by its perceived ease of liquidation.

The Bottom Line

Each financial institution has its own method for analyzing a borrower's creditworthiness, but use of the five Cs of credit is common for both individual and business credit applications. Of the quintet, capacity – basically, the borrower's ability to generate cash flow to service the interest and principal on the loan – generally ranks as the most important. But applicants who have high marks in each category are more apt to receive bigger loans, a lower interest rate and more favorable repayment terms.

RELATED FAQS
  1. Does inflation favor lenders or borrowers?

    Find out under what circumstances inflation benefits borrowers more than lenders and in which situations inflation can be ... Read Answer >>
  2. What’s the Difference Between a Mortgage Lender and a Mortgage Servicer?

    Buying a home is an exciting and confusing process. Once the loan is secured, it's important to know who gets the payment: ... Read Answer >>
Related Articles
  1. Personal Finance

    Personal Loans: Consider These Alternative Lenders

    Looking for an alternative source of financing for a personal loan? Take a look at these companies.
  2. Personal Finance

    Lines of Credit: The Basics

    Learn how lines of credit, hybrids of credit cards, and normal loans, can help or hurt your finances. Determine what is right for you.
  3. Personal Finance

    How To Apply For a Personal Loan

    Learn about different avenues for applying for a personal loan, and learn valuable tips to help you get your personal loan application approved.
  4. Personal Finance

    What Is Collateral?

    Collateral is property or other assets that a borrower offers a lender to secure a loan. If the borrower stops making the promised loan payments, the lender can seize the collateral to recoup ...
  5. Personal Finance

    Can't Get A Bank Loan? Turn To Your Neighbor

    Peer-to-peer lending can be an inexpensive way to gain access to credit when banks are restricting lending -- but you need to understand the entire deal first before jumping in.
  6. Personal Finance

    Home Improvement Loans: What Are Your Best Options?

    If you plan on taking out a home improvement loan, you should know what your options are and which ones might be best for your situation.
  7. Insights

    Forces Behind Interest Rates

    Get a deeper understanding of the importance of interest rates and what makes them change.
  8. Personal Finance

    8 Cheaper Ways to Raise Cash Than Car Title Loans

    Before you sign up for a car title loan, investigate these eight alternate cash-raising strategies rather than using the value of your lien-free vehicle.
  9. Small Business

    Small Business Loan Vs Line of Credit: How They Differ

    Understand the differences between a small business loan and a line of credit, and learn some of the most appropriate uses for each form of financing.
  10. Investing

    Homeowners, Beware These Scams!

    If you're in a pinch for money, you're the prime target for con artists and thieves.
RELATED TERMS
  1. Lender

    A lender makes funds available with the expectation that the ...
  2. Credit Risk

    Credit risk is the probable risk of loss resulting from a borrower's ...
  3. Character Loan

    A character loan is an unsecured loan made on the basis of the ...
  4. Debt

    Debt is an amount of money borrowed by one party from another, ...
  5. Credit Limit

    Credit limit is the amount of credit that a financial institution ...
  6. Maximum Loan Amount

    A maximum loan amount describes the total amount that a borrower ...
Trading Center