The 5 C’s of credit are character, capacity, capital, conditions, and collateral. Together, these serve as a way for lenders to evaluate the creditworthiness of potential borrowers. Banks and lenders generally look at your ability to repay, level of debt, how you plan to use the funds, and the collateral you have to offer.
The better you look as a borrower, the more likely your business will get a loan. Both your personal and business credit scores often play an important role in a lender’s evaluation of your overall creditworthiness.
What the 5 C’s of Credit Are
Most lenders incorporate the 5 C’s of credit to understand how likely you are to repay your debt. Character is reflected in your credit score, capacity measures your ability to repay, capital looks at your total debt, conditions include how you plan to use the funds, and collateral is what assets you’re able to pledge.
The five C’s of credit are:
- Character: Used to measure how trustworthy and reliable you are as a borrower; generally, lenders will evaluate your credit score, credit history ― bankruptcies, foreclosures, and judgments ― and how you’ve handled your debt obligations.
- Capacity: This considers your level of cash flow and measures your ability to repay your debt obligations; banks and lenders are looking to see if potential borrowers have enough cash to pay back what they borrow
- Capital: Banks and lenders look at your level of debt and use your capital as a measure of your leverage; the more equity you have, the lower your leverage, which is a positive thing
- Conditions: Banks and lenders want to understand the current condition of the market, industry in which a business operates, economic environment, how the borrower intends to use the money, interest rate, and the size of the loan; they also want to know how a borrower plans on using the funds from a loan and how the conditions could impact that use
- Collateral: The business and personal assets you can pledge to back the loan; for loans that don’t require collateral, like an unsecured loan, the other four characteristics may have a higher level of importance
By knowing the 5 C’s of credit, you can prepare for what is needed during the approval process of a loan. In addition to knowing what each characteristic is, it’s important to know how banks and lenders will use these during the application and approval process.
How Banks and Lenders Use the 5 C’s of Credit
Banks and lenders use the five C’s of credit to determine the risk of a potential borrower and their creditworthiness. Some lenders go the length of creating point systems for each category while others consider the 5 C’s of credit using their judgment during the approval process.
When you’re shopping for any type of financing the goal is to determine the level of risk you pose as a borrower, decide if you’re a risk they’re willing to take and set your loan terms, which includes your interest rate. If you’re a lower risk borrower, most banks and lenders will offer you more favorable terms and lower interest rates.
Applicants Who Should Focus on the 5 C’s of Credit
The five C’s of credit are generally directed to anyone that wants to get a loan or credit card. More specifically, small business owners looking to apply for a Small Business Administration (SBA) loan, individuals applying for a traditional loan, credit card applicants, and those that want to maintain good creditworthiness should focus on the five C’s of credit.
The four types of people who should focus on the five C’s of credit are:
- Business loan applicants: If you are small business owner getting ready to apply for an SBA loan or other business loan, it’s important to master or improve these factors as they are used to evaluate your risk as a borrower
- Consumer loan applicants: The five C’s don’t just apply to small business financing, lenders also take these factors into consideration for consumer lending products such as mortgages, car loans, and student loans
- Credit card applicants: Whether you’re applying for a small business credit card or a personal credit card, most credit card providers will evaluate the five C’s of credit to determine how much credit to give you; you can search and compare small business credit cards in our credit card marketplace
- Future loan and credit card applicants: If you plan on applying for any type of loan or credit card in the future, business or personal, the application process can be easier if you master these characteristics in advance; this will help you maintain a strong financial health
While these five characteristics are best to focus on if you are going through a loan process or preparing to do that, they are factors you should always keep within reason. This is because they help measure your financial health and overall level of creditworthiness. The better your financial health is, the easier it is to get the credit you need.
How Banks and Lenders Evaluate the 5 C’s of Credit
Although these characteristics are weighted differently per lender, they generally use most of the same aspects to evaluate each category. Banks and lenders will use information such as your credit history, debt-to-income ratio, debt service coverage ratio, cash flow statements, equity, industry factors, and personal assets to qualify businesses for SBA loans or individuals for personal loans.
1. Character ― What Your Credit History & Background Are
Lenders want to take on the fewest risks possible and are hesitant to loan money to borrowers with poor credit history or reputation. When banks and lenders consider character and the five C’s of credit, they look at your personal and business credit history, and they might also look at your reputation.
In regard to your credit history, lenders analyze your personal and business credit scores as they are a reflection of your borrowing history. It’s also likely they will evaluate your personal and business credit report, which shows factors like payment history, liens, and your credit utilization.
Beyond your credit, lenders may also look at your reputation, business or personal references, and how you’ve interacted with those references. Also, they will sometimes evaluate your overall stability as an individual such as how long you’ve lived at your current address and how long you’ve worked at your current job.
2. Capacity ― What Your Ability to Repay Your Debt Obligations Is
Of all the 5 C’s of credit, capacity seems to be the most straightforward characteristic. This is important to lenders because they want to make their money back, plus some interest. For the most part, lenders will evaluate your capacity by considering your debt-to-income ratio, level of excess cash flow, and debt service coverage ratio (DSCR).
The three primary ways banks and lenders evaluate your capacity are:
- Debt-to-income (DTI) ratio: A measurement used for individuals that evaluates the percentage of your monthly debt obligations and your monthly gross income; the lower your DTI ratio, the more willing a lender will be to loan you money and the more debt you can take on
- DSCR: Measures your business’s ability to repay debt by dividing your net operating income by your total debt and interest payments; lenders generally use this to evaluate your capacity because it shows if your business is generating enough income to pay its debt
- Level of excess cash flow: Lenders use your financial statements, including cash flow statements for businesses, to analyze the level of excess cash flow available to repay any debt obligations; excess cash flow is an additional amount of money that you normally need on hand, which can provide additional coverage
Monitoring your debt-to-income, debt service coverage ratio, and cash flow statements are an excellent way to master your borrowing capacity. All lenders want to know if you will be able to repay what you borrow, so this is one of the more critical factors of the 5 C’s of credit.
3. Capital ― What Your Level of Leverage (Debt vs. Equity) Is
Debt to net worth, or debt to equity, is one ratio used to measure capital for both individuals and businesses. A business or individual’s net worth is the value of all their nonfinancial and financial assets. To calculate your net worth, as an individual or business, subtract your total liabilities from your total assets including your investments.
Your debt to net worth shows how financially stable you are as an individual or business by dividing your total debts by your net worth. A lower your ratio suggests you have minimal debts, and you’ll appear as a less risky borrower.
Some other ways banks may look at the capital you’re investing are:
- Loan-to-value (LTV): A comparison of your loan amount to the appraised value of the asset you’re purchasing, like a home
- Down payment percentage: The amount of money you’re bringing as a down payment can be calculated as a percentage if you divide it by the total loan amount; typical down payments are around 20%
4. Conditions ― What the Market, Economic, Industry & Other Factors Are
Banks and lenders generally want to understand the conditions that surround a potential borrower. Typical conditions include the market, a business’s industry, economic factors, how the borrower intends to use the money, interest rate, and the size of the loan.
The conditions banks and lenders consider for individuals vs. businesses are:
- Individuals: How a borrower plans on using the funds, economic factors, interest rate, and the size of the loan
- Businesses: Market, the business’s industry, economic environment, interest rate, and the size of the loan.
These conditions allow banks and lenders to ensure that risks are identified and mitigated. To get some more explanation about business conditions, we sat down with Gary Gomulinski, executive vice president at Alpine Bank who said:
“On the business side, conditions are typically the things within your industry that are outside of your control. They include industry trends, inflation, tax cuts or increases, and the cost of shipping, transportation, and freight. When banks look at the conditions, they ask, ‘What are the trends of the economy?’, ‘Are people buying more or borrowing less,’ ‘What’s happening in the market?’, and ‘Are the trends in your industry increasing or decreasing?’
“We are not necessarily making this judgment ourselves. Instead, we use a third party like an industry analyst to pull a report that shows trends and projections. This report tells us where your company fit in that industry as a whole.”
It’s challenging to identify each lender’s process, but they generally compare how you’re doing relative to your competition.
5. Collateral ― What Assets Are Available to the Lender
Lenders always take collateral into consideration, regardless of whether a loan is secured by collateral or unsecured. However, if a lender or creditor doesn’t require collateral to support the transaction, they may tend to value other characteristic more and require other offsetting factors. They may require a higher credit score, more cash flow coverage, lower leverage, a lower loan amount, or a higher interest rate to offset a lack of collateral.
Loans that are secured by collateral are typically considered less risky than unsecured loans, so you’re going to get better terms in many cases, and it will be easier to qualify. Your business collateral is your inventory, equipment, accounts receivable, and any assets your lender can liquidate if you default on the transaction. Also, a borrower’s home can serve as collateral and back the loan.
How to Improve on Each of the 5 C’s of Credit
The five C’s are important for those applying for a loan and those considering to apply in the future. Some ways you can improve on each of the characteristics include building your credit score and reputation, reducing debts, investing your own money into your business, planning for economic factors, and providing assets to support your loan.
Some ways you can improve on each of the 5 C’s of credit analysis are:
- Character (build your credit score & reputation): You can show that you have good character by building your personal and business credit score; even for businesses, lenders are typically going to rely on both business and personal credit scores; some things that go into your credit scores include timely payments, avoiding defaults on your obligations, avoiding bankruptcy, preventing lawsuits, and paying your taxes
- Capacity (pay down your existing loans): By focusing on reducing your debts, you can lower your debt-to-income and increase your DSCR; this will improve your capacity to repay any loan you take out with a lender or other debt obligations
- Capital (use some of your own cash): Business owners should put some of their own cash into their business and individuals should monitor their levels of personal debt; individuals and business owners can use their capital as an indicator of the amount of financial leverage they have
- Conditions (plan carefully): You can’t control the economy or your industry, but you can plan on how to use your funds; if you apply for a line of credit or personal loan, this shows banks and lenders that you’ve taken action to plan for unexpected economic factors
- Collateral (consider what collateral you can pledge): If you can’t provide enough collateral, consider an unsecured business loan; Before getting an unsecured loan, you should make sure you can pay it off in a reasonable amount of time. If not, create a financial plan and wait until you have enough collateral to support the loan.
Improving and mastering the 5 C’s of credit analysis will help you during the application process for a loan. Focusing on all five characteristics is important because most banks and lenders have a different way of scoring each category.
Frequently Asked Questions (FAQs) About the 5 C’s of Credit
We covered a lot of different information about the 5 C’s of credit analysis and how lenders evaluate each characteristic. Some questions are asked more often than others, and we address those here.
Why Are the 5 C’s of Credit Important?
The five C’s are important because it’s a simple way for banks to evaluate the creditworthiness of potential borrowers. They specifically evaluate your ability to repay, level of debt, how you plan to use the funds, and your collateral. In addition to being used for consumer loans, they also are used for small business financing.
How Can Small Business Owners Use the 5 C’s of Credit?
Business credit reports are important parts of a business’s reputation, and the 5 C’s can help business owners understand their credit. There are many important aspects of a business credit report related to the 5 C’s. Small business owners should check their business credit reports proactively so that there are no surprises when shopping for financing.
Which Two C’s Are the Most Important in the 5 C’s of Credit?
Most lenders look first at your character and capacity because they measure your credit history and your ability to repay. These pieces of information show how you have managed your prior debt obligations and the likelihood you will repay them.
What Is Creditworthiness?
A borrower’s creditworthiness is the likelihood that they’ll default on their debt obligations. One way lenders measure creditworthiness is by evaluating the 5 C’s of credit. The 5 C’s of credit include your character as a borrower, capacity to repay any loans, personal and business capital, economic conditions, and the collateral you have to offer.
The Bottom Line
The five C’s of credit include character, capacity, capital, conditions, and collateral. An analysis of these factors allows banks and lenders to determine if you’re a reliable borrower. Although most lenders consider all of these factors, every lender has its own way of weighting each category.