Synopsis: In today’s blog, we will elaborate on the framework of 5Cs, which lenders utilize to evaluate the creditworthiness and strength of a borrower’s profile.

Lenders, including banks and NBFCs, carry out extensive credit analysis before sanctioning loans to minimize the likelihood of loans going bad. This credit underwriting process is underscored by the 5Cs or five characteristics of credit that are aimed at judging a borrower’s creditworthiness.

Hence, the key to successfully getting capital funding lies in nailing the 5Cs of credit. But what are the 5Cs of credit, and why do banks rely on them for vetting loan applications? Let’s find out.

What is Credit Underwriting?

Credit underwriting is defined as the process of assessing a prospective borrower’s credit risk. Here, lenders aim to analyze and predict the probability of a borrower defaulting on his loan repayments. Therefore, credit underwriting encompasses a judgment about the individual’s or business’ creditworthiness.

The process of credit underwriting involves an evaluation of a borrower on the 5Cs, which are character, capacity, capital, conditions, and collateral. While there is no regulatory standard mandating the use of 5Cs, lenders prefer using these tools to gain a holistic understanding of the borrower’s profile.

However, the use of the 5Cs differs across various lenders, as some (like banks) may give a higher weightage to collateral while other lending institutions may give credence to credit history or current financial position. The new-age financial lenders have been paying attention to qualitative aspects of the business while scoring a customer through ML/AI-driven models on their overall creditworthiness.

Understanding the 5C Framework

Loan seekers can bolster their creditworthiness by addressing the 5Cs, i.e., the five characteristics of credit. Character, capacity, capital, conditions, and collateral round up the top 5, and we elaborate on them below.

1) Character 

Character, or credit history, is one of the most subjective criteria out of all the 5Cs. It is hard to quantify, albeit CIBIL scores are available that judge customers on their creditworthiness. Such scores are generally based on repayments made to other lenders as well as on the number of accounts opened.

The essence of a character judgment lies in approximating a borrower’s historical credit record to future creditworthiness. Based on how an individual has repaid his past loans—are there any late payments, whether credit cards are maxed out, or are there any tax liens—a lender can assess the borrower’s probability of defaulting on loans. They may even conduct individual interviews to gain a better understanding of the borrower’s character.

Things can get a little tricky when evaluating a new business’ character. In such cases, lenders rely on unpacking the owner’s and management’s quality, credibility, qualifications, and reputation.

2) Capacity 

The second C, i.e., capacity, refers to the borrower’s ability to service debt obligations. For this, the lender will take stock of the cash flow position of the loan seeker. Lenders are concerned about whether the individual earns a regular income, earns enough to pay off all the existing loan obligations, and still has the bandwidth to take on more loans.

For business loan applications, financial companies will assess the business on its moats, pricing power, competitive advantages, and the economic landscape it functions in. This is done to ensure that the business will continue to maintain steady cash flows, thereby minimizing the possibility of reneging on loan repayments.

Typically, lenders judge capacity by computing debt service coverage (DSC) ratios and debt-to-income (DTI) ratios.

3) Capital 

In addition to ascertaining a borrower’s cash flow trends, lenders also consider the overall financial position of the borrower. This is done to prepare for a rainy day when an untoward event results in the drying up of cash inflows. 

Thus, lenders look for any unencumbered assets, such as marketable securities and cash, on an individual’s balance sheet that can be sold in case of loan default. They may also take the spouse’s income and real estate assets into account while determining payment capacity.

Whereas for a business loan application, lenders will review the MSME’s balance sheet to understand its capital structure, i.e., the breakup between debt and equity. Additionally, they will be concerned about retained earnings, the possibility of a personal guarantee, or securing a credit line to backstop the proposed credit exposure.

4) Conditions

Here, conditions refer to the terms of the loan and the current economic conditions that may adversely impact the borrower. At the time of processing loan applications, lenders also check the purpose of seeking a loan—is it for purchasing new machinery, scaling the business, meeting work capital needs, or for debt consolidation?

This is accompanied by a proper analysis of the external forces in the macroenvironment and industry-related factors, such as economic cycles (boom or bust), changing government policies, and ever-evolving technology, that may cause a credit seeker to default on payments. 

This becomes especially crucial when the loan tenure is long, and the policy environment is choppy.

5) Collateral

Finally, the last C, i.e., collateral, is a security or an asset against which a loan is secured. Traditional lenders, particularly banks and NBFCs, prefer disbursing loans against a pledged security. This is because, in the event of default, lending institutions will have the option to sell off the asset and recover their money. Often, the collateral is the very object for which a loan is being sought, like auto loans and home loans.

Lenders also check for the quality of assets, as the final loan recovery amount largely depends on it. In fact, in the case of loans against property (LAP), the credit amount given is determined based on the property’s value and is usually restricted to 60-70% of its current market value.

The Bottom Line

While all lenders use the 5Cs of credit, no factor is considered alone, even though their importance varies considerably. Some lenders may give a higher weightage to capacity, while others may prefer going in for a healthy mix of quantitative and qualitative factors.

Of course, it is desirable to be on top of the game when it comes to all the factors, but such a combination is rarely possible. Borrowers must, however, focus on creating and maintaining steady cash flows and a strong financial position to avail of credit at low-interest rates and favorable terms and conditions.