The 5 C's of Credit and Why every Human and Business should know them

BY Mandy Monson

When I was a credit analyst at the bank I learned about money, debt, and cash flow.  I was "lucky" in the sense that I went into banking in October of 2007 and was able to learn the intricacies of underwriting during the longest recession since World War II.  If you are older than 30 years of age, you probably remember that time period known as the Great Recession and according to https://www.federalreservehistory.org/, it lasted from December 2007 to June 2009.

My luck in addition to great timing, is that I was able to learn the craft of underwriting at an exceptional bank, that was ran by a Chief Credit Officer who's previous experience included time with the FDIC.  When I was hired the bank knew that eventually I would be a good production loan officer, but I had not done basic accounting since "Accounting 201 and 202" during my time at University.  Therefore, my 18 month stint in the Credit Department as an Analyst began. 

In my professional life and consulting life today, I still embody and follow the basics of credit underwriting.  Especially, The 5 C's of Credit.  This is where it all begins for any analyst when they pick their file up, and this applies to Consumer, Residential, or Commercial Lending, thus why every human needs to know and understand these concepts.  You may not be a business owner, but you will at some point use credit.  Whether it be a credit card, car loan, home loan, or large business loan, including commercial real estate, the lending decision made by the capital institution all comes back to The 5 C's of Credit.

This article is written for the purposes of you to understand the basics.  As I continue blogging, I will also take a deeper dive into the individual 5 C's, however today, let's get a handle on the general concepts and how lenders use these criteria to determine if you or your business is a good credit risk. 

#1 -  CHARACTER

Think of character as your personal credit personality and footprint that is demonstrated by historical behavior organized in the form of a credit report, credit score, payment history, and whether you have ever filed for bankruptcy.  Character is determined as quickly as performing a credit check via the three main credit bureaus: Equifax, Transunion, and Experian, and or you completing a personal financial statement showing your assets, liabilities, and personal cashflow which is then reviewed and studied by the lending officer at the bank.  

#2 - CAPACITY

Capacity is the business assets cash flow (real estate or operating business)  demonstrating current and future performance and the borrowers ability to pay the lender back.  In the commercial loan underwriting world this is where Debt Service Coverage Ration (DSCR) comes into play and a deep dive of the profit and loss statement occurs in addition to reviewing financial projections and forecasts based on any improvements the borrower is making to the asset in order to improve Earnings Before Interest Depreciation Tax & Amortization (EBITDA) or Net Operating Income (NOI) which should more than cover the estimated debt payments.  Thus, a DSCR can be calculated by taking the EBITDA or NOI and dividing that amount by the total amount of Debt Service (Interest Only or Principal & Interest payment).

#3 - CAPITAL 

Capital is the borrowers own money invested/injected into the project, also known as equity.  This is the borrowers "skin in the game".  The more conservative underwriting for loaning against the asset, the more capital required by the borrower to achieve the approval of the financing request.

#4 - COLLATERAL

The asset/assets you pledge to back the loan.  These could include business, personal assets, or both.  

#5 - CONDITIONS

Conditions is the market analysis of the trends in your business industry.  This includes national, regional, and local trends.  These trends could be macro or micro economic for any one segment or industry.  In regards to real estate, a market survey and competitive analysis is a very diligent process to determine what are the market rents and what is the current occupancy of your competitors.  In operation intensive businesses, it would be looking at how the competition is performing, what is their product pricing, and what is the market share that they currently control in the market.

Borrowing money is never black and white.  Banks use the 5 C's of Credit for their initial review and throughout the underwriting process.  The better prepared you are as a borrower, clearly demonstrating knowledge and strength in the 5 C's, the more efficient you will be at achieving a loan approval.  It will help you to understand the 5 C's so that if you are deficient in one segment, you can mitigate that risk in the credit via another.  Successful borrowers and businesses understand this construct as it relates to borrowing money and know the stronger one can be in each area helps them determine their destiny as it relates to loan approval and successfully negotiating the best rates, terms, and conditions of the loan. 

Any questions regarding this blog post?  Feel free to reach out to me at mmonson@mandymonson.com as I love questions, comments, and suggestions for future blogs and articles.  Also reach out via email if you would like a free pdf of the 5 C's.  Happy to send it your way!