The terms used by lenders during due diligence for lending capital to potential borrowers
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Credit conditions represent the terms used by lenders, such as banks, during the due diligence process for lending capital to potential borrowers. In other words, lenders follow specific rules and abide by a particular system while qualifying individuals and corporations for obtaining loans.
5 Cs of Credit
There are five main conditions lenders utilize to come up with the creditworthiness of potential borrowers. The factors are also named the “5 Cs of Credit” and are as follows:
Character (applicant’s credit history)
Capacity (applicant’s debt-to-income ratio)
Capital (applicant’s capital strength)
Collateral (applicant’s assets that can be pledged against the loan)
Conditions (what is the loan to be obtained for and the amount?)
The “5 C’s of Credit” is a concept to estimate a borrower’s chances of default based on certain conditions and terms of a loan. It includes both qualitative (fundamental analysis) and quantitative analysis (metrics calculation), which means that lenders carefully evaluate the borrower’s financial situation by looking at their overall performance in the open market and financial statements.
Here, a lender wants to know mainly about the borrower’s credit history, meaning how well the borrower has been repaying debt obligations so far and what is its reputation among other lenders.
The information can be found in the borrower’s credit reports that contain detailed information about the amount borrowed in the past and whether all loans were repaid on time. It goes without saying that such information helps lenders a lot in assessing the credit risk of the borrowers.
Importantly, many lenders have a minimum credit score requirement that a loan applicant must have in order to be eligible for loan approval. The requirement varies among lenders.
Capacity is the measure of a borrower’s ability to repay a loan on time by calculating its debt-to-income (DTI) ratio, which is simply a relationship between the borrower’s income and the recurring amount of debt during a particular period.
Lenders calculate the DTI ratio by taking the total monthly amount of debt of a borrower and dividing it by a monthly gross income.
The lower the debt-to-income ratio, the better chance there is for a borrower to secure a new loan. Typically, lenders prefer to see an applicant’s DTI of about 35% or below.
The amount of capital a borrower can contribute to a new project that needs debt financing is also very crucial for a lender during the assessment process. The higher the portion of capital the borrower is ready to invest, the lower the chance of default.
A down payment amount also influences an interest rate and terms of the loan. The higher the down payment, the lower the interest rate will be.
Collateral is an asset that can be pledged against the loan by a borrower. It serves as security for a lender, and in case the borrower defaults, a lender has the right to repossess the collateralized asset and then sell it in the open market to return the loaned funds.
An example of collateral is a property that is purchased on a mortgage or a car using an auto loan. If a borrower puts collateral, it becomes cheaper for them to borrow since the risk diminishes.
Interest rate, amount of principal and amortization, etc. represent the conditions under which an entity borrows funds. Conditions also include an intention to utilize the money, i.e., goals of the borrower, such as to purchase a house or invest in a new joint venture.
The economic cycle of a country, industry trends, or legislative changes are also taken into consideration in credit evaluation.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:
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