Real Estate

5 C’s of Credit

Reading Time: 5 minutes 

“Hey, can you lend me twenty bucks?”

I stopped in my tracks and surveyed the scene in front of me.

A young man, dressed sharply in a suit and tie held out his hand with an air of confidence.

A myriad of thoughts permeated through my mind.

Did I know this person?

Why is he asking me for money?

Will I get it back?

Hm, I hope they still have those tasty Schnitzel sandwiches left.

Where is the nearest toilet by the way, might make a pit-stop.

Image result for chicken schnitzel sandwich

Turning back to the young man, I reached into my wallet and handed over some of my hard-earned…

You see, subconsciously – without even realizing it, I had gone through the 5 C’s of Credit and made my decision.

And before you can ask “number one or number two”? I had already spied the last remaining Chicken Schnitzel sandwich in the food cou… sorry? What’d you say? What are the 5 C’s?

Exasperated sigh

COME ON GUYS! Seriously.

OK OK FINE. Lemme just take you through it.

The 5 C’s are the basic principles of lending and is commonly used as a framework for lenders when they assess the creditworthiness of any potential borrower (whew, I hoped I paraphrased Dr Google well enough there).

Image result for dr google
“Carry on son.”

When you seek a loan, cap-in-hand to the bank or the lender, you’d find that they will run through the 5 C’s when making a decision on whether to provide the loan or not.

The 5 C’s apply from the retail Mum and Dads, all the way up to the big boys in the institutional space.

So what are they?

The first and most important one is character.

This is most important because without suitable character – no amount of analysis, promises, contractual obligation or income will give comfort to the lender that you will be able to pay it back.

You can be the best candidate on paper, have an impeccable work and industry history, even have an exemplary credit record – however if you don’t have suitable character (or integrity), then you can kiss your credit application goodbye.

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“Your credit history is great sir, now if you’d just remove the mask and gloves we should be able to approve your loan.”

This is why at the very least, make sure you obtain and review your credit history regularly – noting your score, any defaults, judgments or actions taken against you.

However even then, if you make the headlines for the wrong reasons, or operate in shady industries – the major players probably won’t look at your file…

The young man was my friend and former work colleague – I felt after knowing him for over 10 years, there was a reasonably high chance I will see that $20 back.

The second one is capacity.

When you think about capacity to repay, most of us think of income. That is – does the borrower have sufficient current and/or future income to repay me back?

This usually means they take all your existing and proposed debts in comparison to your existing and proposed income.

Obviously the more income you can show, versus the less debt you have – the better your application will look.

Image result for titanic sinking gif
The Titanic had more debt than income…

Usually, the lender will note other factors – such as your tenure with your current employer, stability of your chosen industry and most of all likelihood of continuation of income.

My friend has a net wealth and income vastly superior to my own – this gave me reassurance that the odds of $20 being returned were high.

Third is collateral.

Another word for collateral is security – that is what security are you pledging to provide a further level of comfort to the lender?

When applying for a home loan – often the home being bought IS the security. That is why the lender takes a mortgage over the property.

Technically you own it, BUT if something was to happen, the mortgage is the legal document which states that the lender has right to take possession of your home – known as full recourse.

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(Note, although full recourse lending is the staple here in Australia, some of our cousins in the US, decided on non-recourse lending in the lead-up to the GFC, that is, an individual can walk away from the loan for the most part, if they cannot afford to repay…which in my opinion is a bit silly.)

I’d like to think my friend pledged his future friendship in the form of goodwill when entering this transaction…

Fourth C is capital.

Capital is often referred to as “hurt money”. Which translated from banking parlay is the portion of your own equity which you are staking when borrowing.

The more you put in, the more comfort this will give to the lender as it reduces the chance of default.

Coming back to our home loan example, this is why most banks will insist on a minimum 20% deposit unless you are willing to pay for lender’s mortgage insurance (insurance that protects the lender) should you have a deposit lower than 20%.

Their line of thinking is that, as the loan is secured by the property itself – and you are putting in 20% of the transaction in, the property value needs to drop 20% before they lose out on the transaction – that’s if they need to repossess it back.

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“Don’t worry they said. Houses never fall more than 20% they said. You’ll be fine they said”.

A 20% drop in property values is not unheard of (think mining towns recently), but not common in most metro locations.

He didn’t have any capital… that’s why he borrowed cash from me… although in saying so, I don’t think he carries cash in general… just plastic cards… lots and lots of plastic cards.

Fifth and final one is conditions.

Sometimes this is the nitty gritty of the loan contract – such as the interest rate, repayment terms, any covenants and loan amount.

Other times it may be the conditions of the lending environment – that is the viability of your future cash flows and income source.

Think major industry trends – taxi drivers vs Uber or physical retailers vs online disruptors.

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Let me just take you through the conditions of our environmental policy on the future of our trees.

Or it could be the changing landscape of the business you’re in – which may be affected by government policy changes, increased competition even the strength of your customer relationships.

Lenders, they’re a picky bunch.

He was my friend and he needed some cash. That was the only condition really…

So there you go – a bit of an eye opener regarding what is one of the crucial pillars of finance, that is the 5 C’s of Credit!

Hope you learned a thing or two!

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