The 4 C’s of Credit
Banks and organizations assess applicants carefully before giving out any loan. This is because lending to the wrong individual or failing business can put the lenders at risk. While there are several ways to recover the money, it’s a challenging and long process. On top of that, in many cases, lenders need to involve a third party to get their money back. To prevent these situations, lenders use the 4 C’s of credit to determine whether the borrower is worth lending to and what the chances are that they will return your money.
The 4 C’s of credit allows creditors to check different aspects of your financial history. If these 4 C’s show you are a good candidate, you will surely get the approval for the loan.
An Overview of the 4 C’s of Credit
The 4 C’s of credit help to evaluate the condition of the borrower’s credit. The lender verifies the borrower’s credit score, credit report, monthly income statement, and other aspects that can indicate the borrower’s financial condition.
Every lender uses different standards and methods to measure a borrower’s creditworthiness. However, almost all the lenders use the four C’s, capacity, capital, collateral, and character. Checking these 4 Cs is common for both business and individual credit applications.
Read on to understand what these 4 C’s are and how they can impact your finances.
As the name suggests, it indicates the borrower’s ability to pay back a loan. Lenders measure it by assessing your debt-to-income (DTI) ratio and comparing your income against recurring debts.
Also, creditors will estimate your DTI by adding your total monthly debt payments, then dividing the sum by your gross monthly income. If you have a lower DTI, you will have more chance of getting the loan. As we have discussed, every lender has a different ideal DTI, but most lenders require a DTI of less than 35% to approve your loan application.
Keep in mind that some lenders have designed loans for applicants with higher DTIs. This way, many people who are struggling to lower their DTI ratio can receive different types of loans easily.
For instance, you might qualify for a mortgage if you have a DTI of around 43% or lower. In this case, the lender will at least make sure that you are able to repay the loan and don’t get bankrupt after getting one.
A lender will ask how big of a personal investment you are planning to invest in the business. Investing your own money not only shows that there is little chance of default but also indicates that you are serious about your business. Capital also refers to a company’s financial resources it can use to pay back its debts if needed. While measuring capital, a lender will focus on Balance Sheet components like cash flow, net worth, and working capital. Not to mention, lenders will try to understand your financial statements before approving your loan.
Some lenders also look at the company’s short-term equity. This shows the company’s ability to pay them back in the short term. Experts will make sure whether your company has the ability to absorb more debt while looking at where the new loan will fit in your business’s entire debt framework.
Most importantly, lenders will ensure that the documents and data you provide are unaudited, audited, or company prepared. Therefore, they might contact your or the company’s other authorities to understand who prepared the statements.
Keep in mind that lenders might check your past performance on paying back a loan. Nevertheless, their focus is on the future. This is why they will use all possible data and information about you and your company to make sure that they will get their money back.
Collateral refers to the assets and cash a company pledges to get loan approval. We all know that a company also needs to show its ability to make money, excellent credit, and business assets. But your lender will also require you to pledge your assets for the sake of their protection.
Creditors need collateral so that if a business fails, they can secure themselves, and the business owner will bear the burden by paying off debts from their own assets. Furthermore, if you don’t want to give your personal assets for the business, the bank will require you to step down and let the bank take what they can from your business.
When you have collateral at risk, you’re more likely to make your business successful, as the bank or lender will force you to make it work. While collateral may keep the business owner at risk of losing their assets, it increases your chances of getting bigger loans to invest in the business’s expansion and growth.
Character or credit refers to the borrower’s credit history that helps the creditor understand what kind of financial citizen the business or person is. Your lender will predominantly determine your character from your financial history. They will check your credit score and credit report to ensure that you have the ability to pay back the loan later.
Since your score is an important factor in helping you get a loan, you need a good to excellent credit score to get a loan easily. Most importantly, if you want a business loan, you still need a higher personal score to encourage lenders to approve your loan.
Some factors that impact your score are:
- available credit
- late payments
- delinquent accounts
- total debt
Note that personal and business credit are two separate things. Many startups, small businesses, and new companies don’t have business credit, so the company’s owner needs to use personal credit to apply for the loan.
Why Are They Important?
The four C’s of credit give a big-picture framework and an objective that your bank, credit union, underwriter, or lender can use to decide whether or not you are eligible for the loan. These C’s provide an appropriate method of credit analysis. This way, a creditor or lender will determine your creditworthiness. The 4 C’s have a great impact on the loan application process. Whether you have applied for a bigger or small loan, your lenders will analyze your financial condition,
So, when you are planning to apply for the loan, answer the following questions:
- Are you familiar with the 4 C’s of credit?
- Are you willing to make your company succeed?
- Do you have a quality service or product that can stand against the competitor?
- Have you evaluated or researched your competition?
- Is your business compliant with all state, local, and federal regulations and laws?
4 C’s of Credit may only seem like a beneficial aspect for lenders, but if you look carefully, they also protect borrowers from getting stuck with huge debts. Even if you don’t get the loan, you can work on improving your credit history, debt-to-income ratio, and overall financial condition to get the approval for a loan after a couple of months or a few years.