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For many people, getting a loan can be a nerve-racking ordeal. This is especially true for a large loan, such as for buying a house or starting a business. You have reams of paperwork, endless questions about income, assets and debts, and time spent gathering and organizing documents.
But getting a loan doesn’t have to be such a nail-biting experience. The first step to quelling your anxiety (and improving your chances of getting that all-important “yes”) is to gain some understanding of why lenders need all this information in the first place. We demystify the process by explaining the five Cs of credit lenders look at before granting a loan.
It’s all about determining your creditworthiness
The five Cs of credit stand for capacity, collateral, capital, conditions, and character. These five Cs represent the heart of a credit analysis, which is the process by which your lender determines your creditworthiness for a loan. Your lender needs to gauge the amount of risk associated with lending you money.
If the credit analysis indicates you are at high risk of not paying the money back (i.e., defaulting on the loan), there’s a strong likelihood the lender will refuse to lend you money. In some cases, your lender may only offer you a loan at a very high interest rate and/or with other limitations attached.
On the other hand, if the credit analysis reveals you’re a good credit risk (that is, you’re creditworthy and will likely repay the loan on time), your lender might offer to loan you the money at favorable terms.
Let’s review each of the five Cs that make up your lender’s credit analysis.
Financial capacity refers to your ability to take on debt and repay it. Your income is what determines a big part of your financial capacity. While a large income is certainly a point in your favor, that’s not the only thing your lender reviews.
Lenders are also interested in the stability and dependability of your income. They look at your occupation, how long you’ve been at your job, if your income has steadily risen over the years or if you’ve had long periods of sporadic income.
They look at other loans you might have outstanding as this might reduce your financial capacity. Although this can vary, in general, lenders want to see that you’re spending no more than one-third of your income in loan repayment. If you’re applying for a business loan, your lender might look to see if you have previous loans that have restrictions preventing you from getting more loans.
Collateral is what you pledge as security for the loan. Should you default on the loan, then the lender has the right to take over or repossess the collateral.
In the case of a home or car loan, the collateral pledged is usually the house or car. Loans backed by collateral are called secured loans. Lenders often prefer loans secured by collateral and are willing to offer you better interest rates and terms for secured versus unsecured loans.
For business loans, lenders will look to see if you have business assets you could use as collateral. Because it can be hard to value some business assets, they frequently prefer collateral in the form of real property, such as land or buildings.
Capital refers to the total value of the other things you own that you could sell to repay your loan. On your loan application you might have to answer very specific questions about your assets, including the value of financial accounts and real estate. Lenders like to see you have some available capital because this gives you a cushion should you need to liquidate your assets to pay back your loan.
Capital also refers to the amount of money you contribute from your own funds, such as a down payment on a house or car. People who are able to put money down are considered a better credit risk and less likely to default. If you’re able to make a large down payment, you might get a loan with a lower interest rate.
Conditions refers to both the prevailing economic conditions at the time of the loan application along with the terms of the loan itself.
For example, if the economy is in a recession or it appears one is around the corner, lenders tend to tighten the purse strings. If you’re working in an industry experiencing high layoffs, it might be tougher to get a loan even if you haven’t been laid off yourself.
If you’re trying to get a business loan, your lender will look at the prevailing economic conditions in your industry. Other loan conditions the lender will review include the interest rate, the amount of principal, and the number of years for repayment.
Lenders also look at the purpose of the loan. Do you intend to use the money to fund home improvements, buy a new home, or buy equipment to expand your business? You might find it more challenging to obtain a signature loan (one that does not have a stated purpose), especially if the economy is weak or you have very little collateral or capital.
The last of the five Cs of credit is character. Character is a measurement of how seriously you take your financial responsibilities and your track record of meeting these responsibilities.
Lenders look at your credit history and your credit score. Do you have a good record of paying your bills on time? Do you have any delinquencies or judgments against your record? Have you successfully paid off loans in the past? The answers to these questions are an indication of your character.
The Big Takeaway
After reviewing the five Cs of credit, you might have strong feelings one way or the other regarding the odds of you getting a loan. You may realize there are areas you need to work on, such as your credit score, your available capital, or the dependability of your income.
If this is the case, don’t let this discourage you. Remember, your creditworthiness is not fixed in stone. Over time and with effort you can make improvements to it.
The important thing is you now have a better understanding of the process lenders go through to determine whether to give you the loan you want or not. This knowledge is the starting point for you to make improvements if needed or to go out and apply for a loan with confidence.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.