The Five C’s of Lending

Posted on May 12, 2011 by David Gass 1 Comment

The economy goes through cycles; the financial markets go up and down, and the lending environment vacillates between risky and aggressive loan approvals to conservative and questionable loan denials.  Lending and market conditions change; they are rarely stagnant.   And yet, a loan denial for an applicant that seems qualified leaves one wondering why.  Further, how are loans approved for applicants that appear barely able to repay?

Underlying the various lending models are the five C’s. These five characteristics of a loan rarely change, and some would argue never change. The lending market may be aggressive, or it may be slow, but the five C’s continue to be the foundation. Here are the five C’s and a brief discussion of their importance.

Capacity - does the applicant have enough income from their revenue stream(s) to make the payment? This is most important.  The applicant can be well qualified in all other lending criteria, but if the applicant has insufficient cash flow the payment will not be made.

Capital - does the applicant have their own money invested? With more money invested, the borrower will work harder to insure payments are made. Declining housing markets are the perfect example. When houses are worth far less than what is owed, some people simply walk away from the house and the financial obligations associated with the house. If the house has equity, it is unlikely that the owner will walk away.

Collateral – are there assets that can be used if the borrower defaults? If so, the secured collateral is then sold by the lender to satisfy the debt. Normally, the proceeds of the loan are used to buy an asset which then serves as the collateral. Should loan proceeds be used for a purpose other than buying an asset, collateral is typically offered by the borrower to secure the loan.

Conditions – do the current economic conditions have a negative or positive impact on loan repayment? Additionally, conditions describe how the loan proceeds will be used. It is far more comforting to a lender if the proceeds are used to buy assets, rather than to pay off a liability such as a tax lien, payroll expense or other underfunded liability. Lenders are reluctant to lend on paying liabilities because there is often nothing to use as collateral. If the borrower defaults; what is available to the lender to sell?

Character – what is the applicant’s nature?  This is difficult to categorize because of its subjective nature. If the applicant establishes a friendship immediately with the loan officer and the other four C’s are in order, a loan approval is probably forthcoming. Conversely, if all is in order, but the loan officer suspects the applicant to be fraudulent or dishonest, a loan is probably not going to be approved.

In summary, the five C’s listed above should serve as a common sense guide to successful borrowing. If applicants follow these guidelines, they should be in a position to be considered for a loan. While there are additional details to be completed, by following these guidelines many will be done.