Business lending has become a hot topic as of late. Rumors and myths appear as to why banks aren’t lending money to prospective businesses, as well as some borrowers being left in the dark as to why their application for a loan may have been declined. So what is the bank/lender or investor looking for?
When it comes to business lending, a bank or an investor takes on risk in giving applicants money. Think of it when it comes to your own credit card account. The bank made you a revolving (continuously being able to draw on) loan that is unsecured (no collateral involved in case you default and do not make payments). 100% of the risk in giving you this credit falls on the bank. So, how does the bank avert this risk? They charge you interest.
Example Of Business Lending
Let’s use an example of a borrower who was approved for a $1,000 credit card at a 20% Annual Percentage Rate. Assuming that the borrower carries a balance of $1,000 on that card at all times, the borrower would expect to pay back $200 in interest per year. In year 3 after continuing this trend, the borrower would have paid back the bank $600 in interest. Lets now say the borrower lost their source of income and can no longer repay the credit card, and the credit card gets charged off (closed for non payment) by the bank. The bank essentially has lost $400 with no way to recover it. So again, how does the bank avert this risk now to this consumer? Banks have tens of thousands to even millions of credit card customers. These same banks can afford to have a percentage of their borrowers default so long as a majority of the customers pay due to averting risk and having many customers as opposed to one customer. Just like the saying goes, “Don’t keep all your eggs in one basket,” the bank is spreading all of its eggs (credit cards) to multiple baskets (customers).
The 6 C’s Of Credit
With that said, banks unfortunately cannot lend or provide credit to every borrower that applies for each loan. And with that, we will discuss the six C’s of credit; character, capacity, capital, conditions, collateral, and common sense. These six C’s of credit are what each and every bank or investor looks to answer to ensure they are lending to someone worthy of credit to that they can make a sound financial investment in that individual or company.
Character is perhaps the most important of the six C’s of credit, and it is just what it sounds as. Your potential bank or lender is going to ask themselves “How is the character of the person we are making this loan to?” To find out if a borrower has good character, a lender can simply view their character through seeing the borrower meeting payment requirements on outstanding loans including credit cards, mortgages, car loans, etc., on a monthly basis. Are the payments on time? Are the minimums just paid? Is there a legitimate reason that a payment was 30 days past due? These are some of the questions the lender will ask themselves in regards to a borrower’s character.
Capacity refers to the borrower having the financial ability to repay all of their existing commitments as well as paying any new commitment being made by a new/existing lender. Additionally there should be funds left over to cover normal living expenses so that not all income is going directly towards loan obligations. For example, if someone is grossing $2,000 per month, and has $1,500 going towards financial obligations such as mortgages, credit cards, and car loans (anything that is showing on a credit report), is $500 left over going to be enough to survive for the month? This number has to leave the customer enough wiggle room to cover things such as grocery expenses, gas for their vehicle and insurance for that vehicle, entertainment, etc.
Conditions refer to the overall ability of the borrower to meet a financial obligation(s). The lender is going to want to make sure that the conditions of a deal make sense. Has the borrower changed jobs multiple times over the past year? Is the borrower a newly formed business that was created just to change its name because the old name had negative publicity about it? These are the types of things your lender will look into.
Collateral is especially important because it provides the lender with some type of guaranteed value should the borrower default. It is a material item, whether property or possessions, that can have a value assigned to it and would be marketable under normal conditions. Should the borrower not pay back or make payments in consistency of their payment schedule, the lender has the right to take the collateral as their own and market it to recover any monies owed.
Does The Loan Make Sense?
Lastly, your lender will ask itself, “Does making this loan make sense?” Common sense goes a long way into making a wise decision. If a potential borrower seeks a lender for a loan in a line of business that the borrower has never been involved in, the lender may question the reasoning for the borrower going into that line of business. Likewise, if the owner of a business just went through bankruptcy in their business venture, and now wants to create a new business in the same field but needs money to get it started, the lender may be skeptical in making this loan, which circles back to the borrower’s character.
As a potential borrower, it is important that you can meet all of these “qualifications.” Your potential lender no matter how big, small, or whether you are looking at a bank or a private investor, is going to ask itself to answer these 6 important questions. If even one of these questions cannot be answered, or if the deal does not make sense to be done, it may be time to update your business plan so that you can get yourself to the path of success and to credit worthiness.
While there are always exceptions to every rule, please consider putting yourself in the shoes of the lender. Look at your own potential request and see if you can answer to the six C’s of credit. Your banker should be able to provide guidance at all phases of where your business stands and what potential eligibility for a loan looks like. Just because you may not meet all of the six C’s of credit, does not mean you are not worthy of credit. There are varying circumstances to which you may meet none, some, or all of the six C’s and the bank may still lend the borrower money. Each situation is truly its own and requires unique and careful consideration. Make sure you discuss these unique situations with your banker and put yourself on the path to credit worthiness.
*Some information included in this piece has been taken from an article by the CBM Credit Education Foundation, Inc. titled The Six “C’s” of Credit.
*This information is considered an opinion towards the establishment of credit between a lender and borrower and should not represent or warrant the guarantee of obtaining or receiving a loan based on the information provided. This should only be used as a guideline to what a bank may be looking for in the establishment of credit, and each bank or lender will make its own determination to the establishment of credit.
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