In the world of finance, there are a few key components that creditors keep in mind when determining whether certain loans should be regarded as safe or not. Lenders go through a checklist, which is also called the 5 C’s of credit, and if you come up short on two or more of these points, chances are good you will not receive the loan.

In order to actually acquire a loan, these five points must be fulfilled; otherwise you will be considered a risky investment. A few years ago, risky investments were the call signs of numerous banks, but after the market crash and billions of dollars were lost, lenders are now going back to the basics rather than taking calculated risks in the future. The basics of finance are what make up the 5 C’s, which consist of Character, Capacity, Capital, Collateral, and Conditions.

The easiest and cheapest of these points to achieve as a borrower is that of Character. As it is the only point which doesn’t truly require an investment on the borrowers part. Character is made up of the mental and moral qualities distinctive to a specific business, and the reputation they have created for themselves. If a borrower has proven to practice and uphold proper business ethics and morals, this point will be easily covered. However, if a borrower is believed to posses a poor character, or is seemingly untrustworthy, the remaining 4 c’s will not be relevant, nor will they even be considered.

The next point of the 5 C’s that lenders will check for is that of capacity. Capacity is the means and ability of the borrower to repay the loan to the lender. Lenders will check a businesses capacity by studying their financial statements. Lenders will ensure that a borrowers income and revenue can sufficiently cover the cost of the loan as well as other regular operating expenses.

The third of the 5 C’s to be covered is that of capital. Capital is the amount of financial contribution put forth by the borrower. This is important as the more capital put forth, the more faith a lender will have in loaning money. This is obviously due to the fact that if the borrower has a great deal invested, they than have a great deal more to lose if whatever venture they are attempting fails. This capital investment by the borrower instills faith in the lender, and faith is needed if a loan is to be given.

The fourth of the 5 C’s is that of collateral. Collateral consists of property and large assets that can be sold if the borrower is unable to repay the loan. If a borrower has more value in their companies’ assets than the amount they are hoping to receive from a lender, their chances of acquiring a loan are increased. The reason for this is simple; a lender knows borrowers assets can be liquidated to repay debts owed. This gives lenders faith that their investments will not be lost in a worst-case scenario.

The fifth of the 5 C’s is the conditions set forth by the lender to the borrower for a loan. This is essentially the interest rate to be charged and the amount of principal expected to be paid. If a lender is considering the conditions, than the other four points have been met. Conditions are often constructed from the lenders assumptions on the risk involved in providing a loan, as well as what they expect for their ROI. If these conditions can be agreed upon, than the borrower will receive a loan. If not, than the borrower must look elsewhere or ensure that the 5 C’s are covered before making another attempt.

Only a few years ago, creditors would almost accept anything that walked in their door. But the recent financial crash put their risky investments in check, and what they found was that many of their borrowers were defaulting. Banks lost billions and it is all because they didn’t go through the 5 C’s of credit. They made risky investments that may have had large payouts, but more often than not they didn’t pan out for them at all.  

Nowadays, it is much more difficult to receive a loan from a creditor as they are afraid to make the same mistakes as they had before. This is rightly so, you would hear stories of home loans to people without credit or capital. These stories are especially odd when you consider that lenders knew many people couldn’t afford these homes based off their income, but gave them loans anyways. This was with the assumption that a certain percentage would default, but that it wouldn’t exceed those who didn’t and a profit could still be made. Well they guessed wrong, and soon after the housing bubble burst, there were many more loans defaulting than could have been assumed would. This resulted in banking firms closing and others consolidating to stay afloat. Had everyone stuck to the basics of financing, we would not be in this economic recession. Or it would not be as severe as it is.