5 Cs of Credit for Business Owners—What Banks Look For
How to round out your credit and hit everything on your bank’s business loan application checklist
Think of your credit as a pie split into five pieces. Just like a real pie, the pieces aren’t perfectly proportional. Some slices are bigger than others, making them extra interesting to banks. This is, in its most basic form, how banks break down and evaluate credit—piece by piece.
When a bank looks at your credit, they’re trying to estimate the likelihood that you’ll pay back the loan. Most banks assess creditworthiness by looking at five key factors dubbed “The 5 Cs of Credit”: Character, Capacity, Capital, Collateral, and Conditions.
FICO Fun Fact:
- Not to be confused with the Five Cs of Credit, Fair Isaac Corp’s credit score (FICO score) also looks at five factors of your credit to determine your score. These are all paired with percentages. The five FICO factors are:
The first, and arguably most important, factor doubles as a definition for credit itself: Character. When assessing someone’s credibility, what you’re really looking at is their character. If the person is honest, hard-working, and capable, you know you can count on them to pay you back. Banks look for similar qualities when reviewing loan applicants.
- Some versions of the Five Cs of Credit use “Credit History” as the first “C,” considering “Character” and “Credit History” interchangeable.
Credit History is based on payment information reported to the three major credit bureaus: Experian, TransUnion, and Equifax. Information includes status on past loans, liens, bankruptcies, credit card debt, and more. Most of this information is retained for seven years. It is also used to create a credit score.
Your on-paper character needs to be good. However, a person’s true character cannot be distilled to a single number. A good relationship bank will also meet with customers to understand their business, their goals, their motivations, and their personal commitment. This gives intangible insights about a person’s character that can’t be gleaned from Excel spreadsheets. Meeting with your bank’s relationship manager is a good way for you to demonstrate good character in person, a priceless opportunity for business owners looking to fund their small business or startup.
This may seem like a catch 22, but there’s some truth to the old saying: You need money to make money. For a bank to feel comfortable investing in you, you need to show that you are willing to invest in you. Because if you don’t truly believe your business can meet the goals you’re pitching to lenders, it probably won’t. New businesses don’t have a credit history, so banks need to rely more heavily on the “personal capital” piece of the pie.
Capital, or cash on hand, can show lenders several things: previous success in business—or disciplined ability to save—and commitment to and belief in the business plan. It also reduces a bank’s risk. Put simply: the numbers show that a large personal contribution decreases chance of default. The last thing a good relationship manager wants to do is put you in a position where you can’t pay back the loan.
Just because you have the income needed to cover the loan payments doesn’t by itself show you can afford the loan. Banks need to make sure you have enough cash not earmarked for other expenses. Capacity is determined by your debt-to-income (DTI) ratio. This equation is as simple as it sounds: How much more income than debt do you have? In other words, how much wiggle room do you have for making your payments on time? The more wiggle room, the easier it will be for you to make your payments and the more you—and your bank—can breathe.
- Banks want to see that regular income is indeed regular: stable and consist. One way they measure the stability of your job is by how many years you’ve been with a company. Longer tenures equal stronger income.
Collateral is security. It’s how borrowers can secure a loan they might otherwise be ineligible for. It’s also one of the primary ways banks can protect their investment in you. Securing a loan with collateral not only helps the bank minimize risk, it also reaffirms your commitment in your business.
The collateral you choose to use toward the loan is often related to the kind of loan you’re taking out. For instance, a construction business taking out a loan for a crane may choose to use the crane for collateral. It sounds backwards, as they would be using something they don’t yet own, but this is often a good solution for both parties. It allows the business owner to build credit and get something they might not have had the excess capital for, and it allows the lender to minimize risk by securing the loan with a tangible asset that matches the amount of the loan.
Texas Fun Fact:
- Did you know Texas is one of a handful of states with homestead exception laws? Homestead exceptions protect at least some of the value of a person’s primary residence from creditors. Texas has one of the most attractive homestead laws in the country,
- This means your homestead (up to 10 acres) cannot be taken as collateral if you default on your loan.
The most variable of the 5 Cs is Condition. Condition is based on current economic and industry trends—so it can change daily. Like the other big “Cs” a bank’s interest in these trends really boils down to one thing: risk.
A good example of this is overconcentration in volatile markets. Banks must weigh opportunity in markets against the risks and the dependence on regional economies. Even when all industries served are steady, it’s important to stay diversified. The stronger your industry and business trends over the past few years, the more enticing this piece of the pie looks to lenders.
Always stay on top of industry trends. Public stock market data, Google Alerts, and customizable news sites like Flipboard.com and Alltop.com make it easy to track trends. Before asking for a loan, estimate your company’s risk in a market. Put plans in place to protect your company from worst-case scenarios. In addition to natural disaster insurance, interruption insurance and Credit Insurance, can help buffer your business from bad times.