When thinking about loans and credit, it’s important to maintain focus on the basics or the 5 Cs of Credit. Understanding the 5 Cs and its characteristics are applicable to lenders and borrowers alike.
Capital represents the general overall financial position of the borrower or of the credit presentation. Capital is generally reflected through the balance sheet. The balance sheet is a representation of one’s assets, debts and new worth at a single date and point in time. A balance sheet is a fluid, ever-changing document. However, it represents a basic yet fundamental financial picture to your lender.
Capacity is an area that’s critical to credit analysis. Capacity or the ability to absorb and repay debt is of obvious importance to both borrower and lender. When analyzing one’s repayment ability, it’s important to review both the financial return tied to the new debt and look at the person or company’s overall income and repayment position. An engaged lender should analyze and share both aspects with the borrower. He or she should also stress the repayment to account for rate increases or additional debt.
Conditions represents an area where a lender can customize various loan parameters specific to that client or business. Given that each borrower, lender and loan is unique, it makes sense that the loan product should be customized to the borrower and to the loan purpose. For example, one would not want a poultry or cattle loan on monthly or even on quarterly repayment terms if the source of repayment will necessarily come from the poultry and/or cattle production. Likewise, one should expect monthly repayment terms on a loan where most of the borrower’s income is from regular, non-farm sources.
Conditions can also apply to rates, fees, repayment penalties, insurance and many other issues specific to that request. On larger, more complicated loans, it’s advisable to consult an Attorney or other real estate professional to review your loan documents prior to signing off at the closing table. Bottom-line, make sure you understand the terms and conditions of the transaction before signing the closing documents.
Collateral represents the underlying asset that is used to help support the loan request. Collateral can be a great equity source and can be helpful in offsetting other credit areas that may be weaker. A lender should be up front and clear with what’s expected in terms of loan security or collateral. A higher level of pledged collateral can really help if times get tough and you need an extension of time. This can be the cushion that gives a lender the room needed to take advantage of loan servicing tools they have at their disposal. Said another way, a tight collateral margin leaves your lender in a tough position should you need some help and extra time during the loan term. Your lender will consider age, quality and condition of the collateral. On credit requests involving real estate, most loans will involve a State Certified Appraiser.
Character is fifth of the 5 Cs to consider. Character represents the history of one’s borrowing activity as well as the applicant’s level of honesty, ethics and moral capacity. Generally, your lender will do a credit check by ordering and analyzing a credit bureau report on all individual applicants.
Like every other area of life and business, communication is key to a successful, lender/borrower transaction. Be inquisitive and comfortable in asking a lot of questions and you’ll be rewarded with a quality lender relationship that can last a lifetime.
Ken W. Knies is a senior business develop coordinator with First National Bank of Northwest Arkansas, and an agricultural and rural consultant.
