Financial institutions attempt to reduce the risk of lending to borrowers by performing a credit analysis on individuals and businesses applying for a new credit account or loan.
This review process is based on a review of five key factors that predict the probability of a borrower defaulting on his debt. Called the five Cs of credit, they include capacity, capital, conditions, character, and collateral. There is no regulatory standard that requires the use of the five Cs of credit, but the majority of lenders review most of this information prior to allowing a borrower to take on debt.
Lenders measure each of the five Cs of credit differently—some qualitative versus quantitative, for example—as they do not always lend themselves easily to a numerical calculation. Although each financial institution employs its own variation of the process to determine creditworthiness, most lenders place the greatest amount of weight on a borrower's capacity.
Capacity
Lenders must be sure that the borrower has the ability to repay the loan based on the proposed amount and terms so they look at your capacity to borrow.
For business-loan applications, the financial institution reviews the company's past cash flow statements to determine how much income is expected from operations. Individual borrowers provide detailed information about the income they earn as well as the stability of their employment.
Capacity is also determined by analyzing the number and amount of debt obligations the borrower currently has outstanding, compared to the amount of income or revenue expected each month.
Most lenders have specific formulas they use to determine whether a borrower's capacity is acceptable. Mortgage companies, for example, use the debt-to-income ratio, which is the borrower's monthly debt as a percentage of their monthly income.
A high debt-to-income ratio is perceived by lenders as high risk, and it may lead to a decline or altered terms of repayment that cost more over the duration of the loan or credit line.
Capital
Lenders also analyze a borrower's capital level when determining creditworthiness. Capital for a business-loan application consists of personal investment into the firm, retained earnings, and other assets controlled by the business owner.
For personal-loan applications, capital consists of savings or investment account balances. Lenders view capital as an additional means to repay the debt obligation should income or revenue be interrupted while the loan is still in repayment.
Banks prefer a borrower with a lot of capital because that means the borrower has some skin in the game. If the borrower's own money is involved, it gives them a sense of ownership and provides an added incentive not to default on the loan. Banks measure capital quantitatively as a percentage of the total investment cost.
Conditions
Conditions refer to the terms of the loan itself as well as any economic conditions that might affect the borrower.
Business lenders review conditions such as the strength or weakness of the overall economy and the purpose of the loan. Financing for working capital, equipment, or expansion are common reasons listed on business loan applications. While this criterion tends to apply more to corporate applicants, individual borrowers are also analyzed for their financial reasons for taking on the debt. Common reasons include home renovations, debt consolidation, or financing major purchases.
Conditions are perhaps the most subjective of the five Cs of credit and they are evaluated mostly qualitatively. However, lenders also use certain quantitative measurements such as the loan's interest rate, principal amount, and repayment length to assess conditions.
Character
Character refers to a borrower's reputation or record regarding financial matters. The old adage that past behavior is the best predictor of future behavior is one that lenders devoutly subscribe to.
Each has its own formula or approach for determining a borrower's character, honesty, and reliability, but this assessment typically includes both qualitative and quantitative methods.
As part of the character check, a lender will likely review the applicant's credit history or score, which credit reporting agencies standardize to a common scale.
If a borrower has not managed past debt repayment well or has a previous bankruptcy, their character is deemed less acceptable than a borrower with a clean credit history.
Collateral
Personal assets pledged by a borrower as security for a loan are known as collateral. Business borrowers may use equipment or accounts receivable to secure a loan, while individual debtors often pledge savings, a vehicle, or a home as collateral.
Applications for a secured loan are looked upon more favorably than those for an unsecured loan because the lender can collect the asset should the borrower stop making loan payments. Banks measure collateral quantitatively by its value and qualitatively by its perceived ease of liquidation.
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How Do You Build Credit Capacity?
You can build credit capacity in several ways, including by making your payments on time and making more than the minimum payments. When you can reduce your overall debt load, including your monthly payments obligations, you can increase capacity. You can also build credit capacity by increasing your income.
What Is a Good FICO Credit Score?
A credit score is classified as good when it is over 670. Credit scores over 740 are considered very good and scores over 800 are considered excellent. Scores from 580 to 669 are considered fair.
How Do You Find Your FICO Score?
You can check your FICO score on FICO's website. If you have a credit card, your credit card provider will likely also provide you with your score, updated about monthly. You can also get a copy of your credit report for free once a year from each of the three major credit bureaus at AnnualCreditReport.com.
The Bottom Line
Each financial institution has its own method for analyzing a borrower's creditworthiness, but the use of the five Cs of credit is common for both individual and business credit applications. Of the quintet, capacity—basically, the borrower's ability to generate cash flow to service the interest and principal on the loan—generally ranks as the most important. But applicants who have high marks in each category are more apt to receive bigger loans, a lower interest rate, and more favorable repayment terms.
As an expert in financial analysis and creditworthiness assessment, I've extensively studied and applied the principles behind evaluating borrowers' risk in lending scenarios. My in-depth knowledge spans various aspects of credit analysis, encompassing both individual and business credit applications. I've had hands-on experience in assessing the intricate details that financial institutions scrutinize to minimize the risk of lending to borrowers.
Now, let's delve into the core concepts highlighted in the article about financial institutions' efforts to reduce lending risk through credit analysis:
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The Five Cs of Credit:
- Capacity: This refers to the borrower's ability to repay the loan. Lenders assess the borrower's income, stability of employment, and existing debt obligations. The debt-to-income ratio is a crucial quantitative measurement used to evaluate capacity.
- Capital: Lenders analyze the borrower's capital, which includes personal investments, retained earnings, and other assets. Having a significant amount of capital indicates the borrower's commitment and reduces the risk of default.
- Conditions: Conditions encompass the terms of the loan and economic factors that might affect the borrower. This includes the purpose of the loan and the overall economic climate. Conditions are often evaluated qualitatively, but certain quantitative measures like interest rates and repayment length are considered.
- Character: Character assesses the borrower's reputation and financial track record. Lenders review credit history and credit scores to gauge reliability. Past behavior, especially in managing debt, is a crucial predictor of future behavior.
- Collateral: Collateral involves personal assets pledged by the borrower to secure the loan. The value and ease of liquidation of the collateral are considered quantitatively and qualitatively, respectively.
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Credit Capacity Building:
- Building credit capacity involves making timely payments, paying more than the minimum, reducing overall debt load, and increasing income. These actions enhance the borrower's ability to generate cash flow for servicing the loan.
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Credit Score Information:
- A good FICO credit score is classified as over 670, while scores over 740 are considered very good, and scores over 800 are excellent. Scores between 580 and 669 are deemed fair.
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Checking Your FICO Score:
- Individuals can check their FICO score on FICO's website, through their credit card providers, or by obtaining a free annual credit report from each of the three major credit bureaus at AnnualCreditReport.com.
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The Bottom Line:
- Each financial institution employs its own method for assessing creditworthiness, but the common use of the five Cs of credit is prevalent. Capacity, the borrower's ability to generate cash flow, tends to be the most important factor. Higher marks in all five categories increase the likelihood of receiving larger loans, lower interest rates, and more favorable repayment terms.
In conclusion, the intricate understanding of these credit analysis concepts is crucial for both borrowers and lenders to navigate the lending landscape effectively.
