The 5 C’s of Credit

This post was originally published by Community Credit Lab, which is now part of Common Future.

When applying for a business loan, banks and other lenders typically refer to the “5 C’s of Credit” to evaluate a potential borrower’s eligibility and creditworthiness: Capacity, Capital, Collateral, Conditions, and Character. While the 5 C’s are often touted as an objective qualifiers, in practice we know this isn’t the case due to the prevalence of discrimination in the financial system: per McKinsey’s study this past summer, “even when controlling for [other] factors, Black-owned businesses are still 20% less likely than white-owned businesses to obtain a loan from a large bank.”

CCL’s team recently reviewed the 5 C’s, discussed potential issues with each, and identified how we can incorporate shared learnings to facilitate access to affordable credit and, ultimately, shift power in the financial system. We sought to take a nuanced view by evaluating potential barriers, potential benefits, and honing in on “CCL’s Viewpoint” and “CCL’s Approach”. These viewpoints and approaches are informed by over 25 years of experience in lending and finance across CCL’s team and Board as well as feedback we’ve received from our Lending Partners and borrowers to date. That said, our viewpoints are never static and will continue to evolve based on ongoing learnings and feedback we receive. Read how one of our Lending Partners is also reimagining the 5 C’s.

Capacity

Overview: Capacity is a business’s ability to repay loans and lenders typically review a business plan that demonstrates steps to repay loans. Specifically, lenders look at revenue, expenses, cash flow, and repayment timing and may review business and personal credit scores.

Potential Issues. While business plans may drive necessary consideration and analysis by the business owner, “non-traditional” business plan formats are typically discouraged by lenders. This perpetuates a disadvantage to people who aren’t familiar with this format or don’t have the time to create a conventional business plan. Further, a conventional and “correct” business plan may not fully be part of a lending decision given that much of a lender’s analysis is typically based solely on the financial information in the plan. This leads to unnecessary time spent in the loan application process for the business owner and unnecessary costs spent by lenders to review longer plans—these costs translate to higher interest rates and fees for borrowers.

CCL’s Viewpoint: The main question we ask with prospective Lending Partners that seek to establish a commercial (i.e. small business) Lending Program for their community is whether the loans will be “right-sized” for businesses based on current or expected financials. To date, our Lending Partners have also emphasized this in their business services. We agree with our Lending Partners that people and small businesses should not be put into debt if they can’t afford it—we also agree with our Lending Partners that a formal business plan is not necessarily the best way to evaluate this.

CCL’s Approach: CCL relies on Lending Partners to provide bespoke services that are culturally appropriate and understand the nuances of a business operating in a specific context or industry focused on their communities in their geographies. CCL’s Lending Partners often support putting the financials together and connecting people to resources where they can seek guidance, then CCL enables the Lending Programs by reviewing the loan applications and financials against the criteria our Lending Partners establish for their communities.

Capital

Overview: The cash that people put towards starting their business is called capital, and it’s a traditional way for a lender to evaluate the commitment of a borrower. Capital may come from deposits or money from other sources.

Potential Issues. Lenders often expect an individual or business to have invested or maintain a portion of the loan under consideration — whether it be 10%, 20%, or 30%. Factors that influence this number may be the industry in which the business operates, time in business, or other indicators the financial institution deems applicable at the time, based on factors that are often external to the business. This requirement creates a perception that people who have access to fewer resources are inherently riskier—which we know is not the case. The capital requirement clearly and unfairly creates a barrier for people who have been systematically excluded from participating in programs and accessing affordable capital to support wealth accumulation.

CCL’s Viewpoint: The financial system extracts more from people with fewer resources — and people with fewer resources are often discriminated against based on race, gender, or other demographic factors. We remove the barrier of capital to support people to achieve their goals effectively and recognize historical barriers that people have faced to building wealth and capital.

CCL’s Approach: To date, none of our ur Lending Partners require capital as a component of underwriting in their Lending Programs and we expect this to remain consistent due to the shared goal of creating pathways to “yes” for borrowers who face discrimination and extractive lending practices elsewhere. Instead, our Lending Partners value relationships and trust above the “Capital” requirement by asking questions like: How engaged are people in the networks they are a part of or How rooted is their business in a community?

Collateral

Overview: When evaluating a loan application, a traditional lender will generally look at collateral (i.e. physical assets including vehicles, inventory, equipment, etc.) as a potential secondary source of repayment for the loan if/when cash flows from the business are insufficient. Traditional lenders want to make sure that if the loan payments stop for some reason, they can recover what they’re owed through collateral. Loan amounts will often be based on a percentage of the collateral’s perceived value, which is called the loan-to-value ratio (LTV) and different types of collateral often have different LTVs.

Potential Issues: Similar to the capital requirement, requiring collateral creates barriers for many individuals who have not had access to opportunities to build wealth and accumulate assets as a result of facing discrimination within the financial system. The requirement of collateral also creates a self-reinforcing cycle of exclusion—in order to access capital from a traditional lender you need to have collateral, but in order to have collateral, you most likely need to have access to capital to purchase the assets that can serve as collateral. In some instances, exceptions are made to provide a loan without sufficient collateral—but often times that means that the individual will be charged a higher interest rate—creating yet another hurdle for a borrower to overcome over the long term.

CCL’s Viewpoint & Approach: CCL and its Lending Partners do not view the accumulation of physical assets or intellectual property as an indicator of whether or not someone should have access to affordable capital. Instead, we think about collateral as an intangible—how connected you are to your community, networks, and Lending Partner. With continued support from those around you, it is more likely that you will succeed in achieving your goals.

Conditions

Overview: Traditional lenders often require businesses to demonstrate that there’s a market for their business service(s) or product(s) and a clear purpose for the loan. Businesses are typically encouraged to base their arguments on local, regional, and national economic factors, the competitiveness of the business, the type of industry and the owners’ experience in it, and the owners’ experience managing a business.

Potential Issues: At face value, the information requested can be helpful to a business owner to understand and support building their strategy. The barriers people may face with this requirement is that traditional lenders may be looking for this information in a specific format that someone with less mainstream experience may not know, or may have unstated assumptions about which industries are more successful, or how many years of “formal” management experience a business owner should have to successfully run a business. Often these benchmarks are not shared transparently and have been created based on who the traditional lender has historically lent to—which has been influenced by all the other C’s in this formula. Transparency into how these factors are evaluated is required in order to untangle assumptions that continue to exclude individuals that face discrimination in the financial system.

CCL’s Viewpoint & Approach: CCL and its Lending Partners know that understanding the industry, competitors, and economic factors that can influence your business is important. Our Lending Partners often work with business owners to uncover some of these insights and build a plan to manage risks to a business. Having and adapting the plan as a part of overall strategy is what matters and CCL and its Lending Partners trust the business owner to know its business best.

Character

Overview: The final C traditionally includes a review of the Borrower, including their educational background, business experience, and personal credit history. Personal credit history is deemed to be important by traditional lenders because they may require personal guarantees of the loan. References or other background information will typically also be considered under Character and it helps if owners and employees have experience and a positive reputation in their business’s industry to be approved by traditional lenders.

Potential Issues. A number of issues and barriers are present with “Character” in its traditional evaluation: namely, the way to evaluate Character is inherently biased and subjective. For more subjective measures, we need to ask who is making the evaluation and are they equipped to make these assessments? In an effort to move away from more subjective measures, traditional lenders have also leaned heavily on credit scores to evaluate character. However, credit scores have proven to reinforce the negative perceptions lenders—someone with no or limited credit history will often get a higher-cost loan. This may result in a person not being able to afford the monthly payments and subsequently may be late on payments or default on the loan, which then hurts their credit score. The next time they apply for a loan, they are stuck in the same cycle. Credit scores also may not include payments that many people are making on a monthly basis, like rent. Either due to the deficiency of the tool used to measure Character or the way Character is being evaluated, the current methods are insufficient in effectively evaluating a person’s ability, willingness, and accountability to repay a loan.

CCL’s Viewpoint: At CCL, we and our partners often use the phrase “Character Based Lending” but we don’t mean it in a traditional sense. Fundamentally, trust and relationships are essential in understanding how a person shows up in their community.

CCL’s Approach: Our Lending Partners are building with the people they know and commune with, and are in communication with about what their needs and next steps are: it’s about how people are showing up in their communities. For CCL’s Lending Partner, Native Women Lead, this is about being part of their network and voting on who gets access, as well as how people are supporting and showing up for one another. For CCL’s Lending Partner, MORTAR, this is about being in relationship with their alumni network.

Summary

As a facilitator of Lending Programs on behalf of communities that face discrimination in the financial system, CCL comprehends and continues to weigh the significance of the barriers that tools like the 5 C’s Present and how we can eliminate barriers to effectively support the goals of our Lending Partners. Our regenerative Lending Programs seek to replace or restore damaged or missing access to affordable credit.

As we continue to support the design of affordable Lending Programs, our Lending Partners will continue to decide which of the above factors may or may not be relevant for their communities, if any. We are sharing the above reflections as a starting point for discussion, more critical thought, and conversation, not a definitive guide to what is right or wrong with the 5 C’s of Credit. Please feel free to contact us to discuss the above ideas further, share how the 5 C’s have been problematic for you or your community, or ideate on how to think differently about facilitating equitable access to credit for your community with Community Credit Lab.

References

Navy Federal Credit Union. (2021, March 5). The 5 C’s of Credit. https://www.navyfederal.org/resources/articles/small-business/the-5-cs-of-credit.html

National Institute of General Medical Sciences. (n.d.). Regeneration. https://www.nigms.nih.gov/education/fact-sheets/Pages/regeneration.aspx