When you apply for a loan, the lenders need to know if you will be able to repay them. In order to determine your potential to return the loan, lenders have come up with a system to gauge your trustworthiness. They don’t simply take your word for it when it comes to setting up a repayment plan. Instead, lenders use the 5 C’s of credit to evaluate your application.

What are the 5 C’s of Credit?

It is a kind of system used by lenders to determine the creditworthiness of applicants for loans. By analyzing the borrower’s characteristics and the kind of loan they are applying for, lenders can calculate the risk of financial loss in the event of non-payment or default by the borrower. 

The 5 C’s of credit are the following:

Character

Definition: It is the lender’s judgment of your credibility, reliability, and ability to fulfill responsibilities.

Use: A lender wants to accept people who are more likely to return the loan in order to keep their risk of financial loss to a minimum. They prefer people with good credit scores that reflect creditworthiness, trustworthiness, and a sense of responsibility towards financial obligations.

Method of Evaluation: Credit history and credit score is the most important determining factor of your creditworthiness. Your work experience, how you get along with your colleagues, reputation among lenders and banks, and references matter a lot.

Capacity

Definition: Capacity or cash flow reflects your ability to pay back the loan.

Use: Lenders are always concerned about getting their money back and so they want to lend to people who have a greater chance of making full repayment. They want to know if your business generates enough cash flow or you have enough income to pay them back.

Method of Evaluation: The hallmark of capacity and cash flow is the debt to income ratio. Your income should be enough to pay the bank in installments. Other methods include financial metrics include cash flow statements, credit scores, and borrowing and repayment history.

Capital

Definition: it is the amount of money that a business owner has invested or the amount of money that the applicant has.

Use: Lenders are more eager to pay people who have already invested in a venture, it shows commitment and greater chances of success.

Methods of Evaluation: The amount of money invested in the business or money in a bank account.

Conditions

Definition: It is defined as the purpose of the loan you are taking. It also includes the conditions of your business whether it is growing or faltering. 

Use: Lenders need to calculate risk before giving money and they want to lend to people who are working in favorable conditions. 

Methods of Evaluation: Supplier and consumer relationships, business plans, industry trends, and competitive landscape.

Collateral

Definition: Collaterals are the financial assets that act as insurance for the lender to secure a loan.

Use: It is a backup source of money for the lender in case the borrower fails to return the money.

Methods of Evaluation: Real estate including the house of borrower, cars, working capital, etc.