Would you lend $5,000 to a good friend—assuming you have it? If so, what is the time frame you would consider giving your friend to pay you back in full? How will you ensure that your friend pays you back? Will you hold onto something of value from your friend to ensure that your loan is paid? If your friend fell on hard times and had difficulty repaying you, how would you respond? If your friend simply neglected to pay you back, do you think it would put a strain on your friendship? Most of us would have to really think it over before we commit to lending a personal friend that type of money.
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Would you lend $5,000 to a complete stranger? Probably not. But lending large sums of money to strangers is exactly what banks and financial institutions do on a daily basis. They literally issue millions of dollars daily to complete strangers. Selling money, which is what lending boils down to, is big business! However, there is also inherent risk in lending. For starters, nobody knows what tomorrow will bring. Those who have great financial and credit profiles today can take a turn for the worst over night. Secondly, due to rising prices, the money you borrowed today may not have the same purchasing power it once enjoyed when the loan is repaid in full—particularly on long-term loans. The risk goes on.
Those who engage in the business of selling money (lending) adhere to what is commonly referred to as the “3 Cs of Credit.” These principles are the bedrock of lending decisions. These principles are followed in all lending classifications including personal loans, student loans, car loans, credit cards, mortgages and business loans. Evaluating credit applications utilizing the principles of the 3 Cs of credit allows lenders to mitigate risk—weed out loans that have a high probability of defaulting. Understanding these principles will give you a better understanding of how to qualify for loans. Another thing to ponder as you review the 3 Cs of credit is this: Since lenders analyze the 3 Cs of credit to justify whether or not potential applicants are credit worthy, those who invest—lend money to small and large corporations—you should employ the same tactic when considering what companies to invest your hard earned money. Below we will detail the 3 Cs of credit.
Character: Character represents the highest importance of the 3 Cs of credit. It measures the borrower willingness to repay the loan. A review of a borrower’s personal and/or business credit report will reveal a borrower’s past performance in making payments on time. A person and/or entity who has demonstrated a timely payment pattern over a period of time is considered a good credit risk.
Capacity: Capacity measures the borrower ability to repay the loan. A review of a borrower’s cash flow (income vs. expenses) will reveal the amount of new debt a borrower can reasonably handle. A lender will verify a borrower’s income by way of W2’s, tax returns, pay stubs, and/or financial statements. The lender will compare the income to the borrower’s existing debt obligation. Lenders have various debt ratio tests to ensure that the borrower will not be overextended with debt upon granting the loan to the borrower.
Collateral: Depending on the complexity of a loan, a lender may require that a borrower pledge something of value as security for the loan. In the event the borrower is unable to repay the loan, the lender will seize and liquidate the collateral to recoup a portion or all their money. In addition to evaluating the collateral securing the loan, the lender also likes to see other assets that a borrower can liquidate in the event of a cash flow problem. Other assets include savings, 401(k) plans, stocks, mutual funds, IRAs, money market accounts, annuities, office equipment, etc.
There are other less known Cs of credit namely circumstances leading to a loan request, contingencies (pending debt obligations), Conditions (restrictions on the use of funds) and competency of management. These particular Cs of credit are evaluated when reviewing loan applications for large companies.
If a good friend should want to borrow money from you, instead of saying “No,” you can say, “I’m not sure if you have the capacity to take on additional debt (smile).
(Damon Carr is the owner of ACE Financial. He can be reached at 412-856-1183 or visit www.allcreditexperts.com.)
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