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The 5C's of credit: What banks & lenders look for

By Louise Chan · July 02 2019
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Borrow

The 5C's of credit: What banks & lenders look for

By Louise Chan
July 02 2019
Reading:
egg
egg
egg
The 5C's of credit: What banks & lenders look for

The 5C's of credit: What banks & lenders look for

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By Louise Chan · July 02 2019
Reading:
egg
egg
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The 5C's of credit: What banks & lenders look for

You may often hear about potential borrowers who are struggling to fix their credit scores in order to increase their chances of getting approved for a loan or other credit product. However, an applicant’s credit report isn’t the only thing that banks and other credit providers look at before deciding whether to approve or reject a loan application.

Banks and business lenders usually follow a framework to determine a loan applicant’s creditworthiness. This framework, called “The 5C’s of credit”, determines whether the lender can trust the borrower to pay off the full loan amount based on five characteristics that reveal their financial situation.

The 5C’s of credit

  • Capacity: Assesses how much money can be borrowed and repaid.
  • Capital: Measurement based on how much money the borrower will contribute.
  • Character: Assesses whether the borrower can be trusted to pay back their debt.
  • Collateral: Serves as insurance for the lender.
  • Conditions: Determines how well a borrower can manage in changing economic conditions.

Here’s what each category means for the borrower’s creditworthiness.

Capacity

Capacity refers to how much the borrower can realistically borrow based on their income, expenses, existing debts and debt-to-income ratio.

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Debt-to-income ratio is the total of all expected monthly debt repayments (including interest) divided by your monthly pre-tax income. This gives creditors an idea of whether the loan applicant can consistently meet loan payments regularly or they may have trouble meeting their obligation.

Lenders may look into the borrower’s net worth and personal credit history to find out if they have other outstanding debt obligations. The information they gather may determine whether they have enough spare money to repay the new loan.

A business owner, on the other hand, may be measured according to their business’s working capital, cash flow statements and credit rating.

Capital

Lenders may also assess a loan applicant’s creditworthiness based on the borrower’s confidence on their intended purchase for the loan. By “confidence”, we mean the borrower’s certainty with regard to the asset they will purchase using the borrowed money. Lenders measure this based on the amount of the personal money that the borrower is willing to put towards the purchase.

This money also refers to the “deposit” for the loan.

Take, for instance, two housing loan applicants who are borrowing $500,000 to buy a piece of real estate in the same suburb. Both loan applicants have a savings account to their name containing $120,000. However, while borrower A has prepared $100,000 of their own savings to contribute as deposit for the purchase of their home, borrower B is only prepared to use $40,000 from their own money. 

In this case, borrower A has a higher chance of getting their loan application approved because the lender would consider their large capital as a sign that the borrower is sure about owning the asset. Borrower A’s chance also increases because the lender would be risking a smaller amount of money ($400,000 v $460,000).

However, this doesn’t mean that a borrower’s loan application would automatically get rejected if they don’t spare a large capital. The lender would still look at the other four C’s, among other things, before making a decision.

Character

Character is all about how financially responsible and credible the debtor is perceived by the lender based on the borrower’s management of past and current financial commitments. The good news is that “character” is largely based on the borrower’s actions.

If lenders see that a borrower has been financially responsible with managing finances and personal credit, including debt services, the chances of getting a loan approved may increase.

On the other hand, an applicant who doesn’t have a track record of consistently paying their debts on time, such as with credit card debts, or one who has filed for bankruptcy may be rejected.

For business owners applying for a small business loan or any type of loan for company use, lenders also look into their financial track record, such as how well they manage contracts and debts and how trustworthy they are in their industry.

Collateral

Collateral refers to the security that the borrower can offer to the lender as insurance in case they default on the loan. In a worst-case scenario, the lender has the right to take the pledged asset and sell it so they can recover the amount that is owed.

The collateral may be the asset purchased with the borrowed money or other personal assets that the lender would accept, such as the borrower’s house, car or valuable collectables. Business owners may also offer their business property, equipment or inventory.

Conditions

Conditions refer to the terms of the loan and the current economic conditions.

Lenders take into consideration the amount of money that is being borrowed, the duration of the loan and what the loan will be used for. Loans for a specific purpose, such as a home loan or car loan, typically have a better chance at approval than a generic personal loan. 

The loan’s purpose, along with the terms of borrowing, such as the principal amount, interest rate and duration, helps lenders estimate the borrower’s need or financial circumstance.

It’s not that one type of need is greater than another. Rather, lenders tend to be more relaxed with approving loans when the borrower doesn’t have a great need to take on debt to meet their needs.

To make its assessment more objective, lenders also consider the current economic conditions vis-á-vis the loan conditions and purpose applied for. This gives them an idea of how consistent the borrower’s repayments would be if economic conditions change, such as when interest rates move, inflation increases or the economy experiences a downturn.

How to increase your chances of getting approved for a loan

The 5C’s of credit is the basic framework lenders follow, but it’s not the only way to assess a loan applicant.

To increase their chances of securing a loan, it’s best for potential borrowers to build a good reputation of paying debts or managing their finances prior to applying for a loan.

Another way is to build a good relationship with the loan provider for at least a year before getting a loan so that the lender is aware of their good financial standing and character. 

 

Explore Nest Egg for more information on loans, debt and borrowing.

The 5C's of credit: What banks & lenders look for
The 5C's of credit: What banks & lenders look for
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About the author

Louise is a content producer for Momentum Media’s nestegg who likes keeping up-to-date with all the ways people can work towards financial stability in 2019. She also enjoys turning complex information into easy-to-digest, practical tips to help those who want to achieve financial independence.

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About the author

Louise is a content producer for Momentum Media’s nestegg who likes keeping up-to-date with all the ways people can work towards financial stability in 2019. She also enjoys turning complex information into easy-to-digest, practical tips to help those who want to achieve financial independence.

Join The Nest Egg community

We Translate Complicated Financial Jargon Into Easy-To-Understand Information For Australians

Your email address will be shared with nestegg and subject to our Privacy Policy

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