If you’re thinking about starting a business or expanding your existing company, you may need to take out a small business loan to cover the cost. At that point, you need to ensure that you are the strongest borrower possible in order to increase your chances of getting the loan and landing the best terms.
Below we will explain the 5 C’s of credit, which banks, financial institutions, and Community Futures use to evaluate borrowers. Learn how to boost your odds of receiving a small business loan and then reach out to Community Futures to see whether one of our loan products are right for you.
THE 5 C’s OF CREDIT
When assessing a borrower’s financial strength and their potential for defaulting on a loan, banks and financial institutions look at 5 elements:
- Capacity
- Capital
- Collateral
- Conditions
- Character
CAPACITY
One of the first things that financial institutions review after receiving a loan application is the potential borrowers’ credit report. This is an overview of their financial situation including:
- Past loans they have borrowed
- Amount of debt paid off in the past
- Amount of existing debt
- Number of late payments vs. on-time payments
- Bankruptcies or other financial red flags
The lender will also dig up the applicant’s credit score, also known as a FICO score, which is the three-digit number that summarizes their credit history. Lower scores (closer to 300) combined with a high percentage of debt tend to indicate risky borrowers, while higher scores (nearer to 900) and low to no debt signify dependable borrowers.
Finally, banks will assess whether the applicant has the ability to pay back the loan based on their income and monthly financial obligations. For instance, if the applicant’s mortgage and utility bills already eat up 80% of their monthly income, they probably aren’t a good candidate for a hefty business loan.
Tip: Check out Community Future’s Loan Calculator to estimate what you can afford.
CAPITAL
Prospective borrowers who have additional financial assets—significant savings or a retirement nest egg— that they can fall back on during times of financial hardship are much more appealing than applicants who have no assets. This doesn’t mean that aspiring entrepreneurs without thousands in their savings accounts are barred from receiving loans, but it is important to understand that banks do take this fact into account.
COLLATERAL
Collateral is an additional form of security that can be used to repay the loan if the primary source dries up. This could include:
- Equipment
- Property
- Accounts receivable
- Business assets
- Personal assets
Lenders want to know that should the borrower default, there is still a way to recoup their investment—by selling equipment and property for cash. Though this may not be the most important factor of a potential borrower’s profile when compared to something like credit history, some lending institutions will require a general lien on a borrower’s business assets when extending a loan in order to protect themselves.
CONDITIONS
What does the economy look like? Is the applicant trying to start a business in a risky market that experiences a high failure rate? Or, if the applicant already owns a company and is trying to source more capital, are the sales figures strong? The ability to borrow depends on more than having assets and a strong credit history—lenders will also analyze external conditions when considering whether to lend money.
CHARACTER
“It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”
- Warren Buffett -
Character refers to the applicant’s reputation. Do they appear trustworthy based on their track record of business? Have they been at their current address and job for a while or do they tend to skip around a lot, meaning that they may be more likely to abandon their business and skip out on loan repayment? With regards to small business loans, it’s true what legendary businessman Warren Buffett says: reputation is everything.
PUT YOUR BEST FOOT FORWARD
It’s okay if you’re not a perfect applicant right now; the key is to steadily improve your financial situation and become a more appealing borrower. Use the information above to determine which “C” needs the most work and then write out a plan of action.
For instance, if you would like to improve your credit score, see what you can do about minimizing existing debt. Our e-book, Money Mastery for Small Business Owners, walks you through creating and managing a business budget so you can pay bills on time. Click here to download the e-book!
If you have additional questions about small business loans and whether one is right for you, contact the helpful professionals at your regional Community Futures office.
