Have you ever wondered how and why your loan application gets approved or denied sometimes? The five C’s is a system used by financial lenders to gauge creditworthiness. It assesses the likelihood of repaying a loan and determines loan qualification. Lenders look at credit history, credit scores, income or cashflow and other relevant documents in order to determine the ability to pay. It is therefore important to understand them in order to improve eligibility when applying for a loan facility.
Below are the five C’s and how they are used.
Character
This touches specifically on credit history. The bank looks at track records on the repayment of previous loans and whether they were paid on time. This information can be found in credit reports which the bank can access from accredited organizations such as Transunion, Central Reference Bureau (CRB), Credit Info or Metropol. These reports are used by the bank to evaluate credit risk and determine credit score. The credit score will then determine loan approval, the terms of the loan and the loan rates.
Capacity
This measures your ability to pay the loan by comparing the borrower’s cash flow and income. The bank will look at the debt-to-income ratio. If the incurred debt is more than the income, the loan will not be approved because the chances of loan default increase significantly. The bank’s main focus is to reduce the risk of financial loss in the event that a borrower stops making payments.
Collateral
This is the asset used to secure the loan. They are personal assets such as land, a house, a car or the investment you are taking the loan facility for. They are measured both quantitively in terms of value and qualitatively in terms of ease to offload. Banks respond more favourably to loans that have security because they can collect the asset to offset the financial risk of the defaulted loan.
Capital
This is your personal investment, for example, savings, assets and down payment into the business venture or investment idea. Banks analyze the business’ capital structure and financial stability to assess its ability to absorb losses or financial setbacks. Borrowers are trusted not to default in payments because they have invested their money in the venture which acts as additional motivation not to default. Capital is calculated quantitively as a proportion of the total investment.
Conditions
These are the terms of the loan facility. They are determined by the bank and they include timelines to pay, the payment installments, loan amount, usage of the loan facility, current interest rates and value of the asset. Breach of these conditions could lead to loss of financing because the breach becomes a financial risk to the bank. It could also lead to personal assets being seized and auctioned.
Knowledge of these five C’s will help in understanding how and why a loan is approved or denied. It will also help in knowing how to improve creditworthiness and understand credit reports so as to improve your loan eligibility.