What are the 5 Cs of credit? And why they matter when applying for a loan

Before we had credit scores that could evaluate loan applications in seconds, lenders manually reviewed loan applications. Somewhere along the line, the factors most lenders look for were distilled into the 5 Cs of credit. They are designed to explain the broad factors lenders use to approve loans — character, credit, capacity, capital, and collateral.

We’ll break each down in detail here. Like the advice to eat 5 servings of fruits and vegetables a day, though, the 5 Cs can seem a little vague. 

Do I have to eat green veggies? Do potato chips count as a vegetable? 

What does good character mean? Will lenders check my social media before they give me a loan?

Still, they have value if you’re learning how to understand what lenders may be looking for when you apply for financing.

Here we’ll explain the 5 Cs and help you how to leverage them in your business.

What are the 5 C’s of credit and why are they important?

The 5 Cs have been used for decades to describe the handful of metrics lenders have used for years to evaluate a potential borrower. They stand for: 

1. Character
2. Credit
3. Capacity 
4. Capital 
5. Collateral

These factors are trying to help answer the main questions lenders have when reviewing an application: 

1. Can the borrower repay the loan?
2. Will the borrower repay the loan?
3. What happens if they can’t or don’t?

The 5 Cs: A detailed breakdown

Here’s how these factors can apply if you’re looking for a small business loan today.

Character: Your reputation

Character is an important part of how a lender may size you up. Twenty years ago, you may have gone to your bank and asked for a loan based a lot on your reputation. That type of small business lending doesn't happen much any more — most smaller loan applications are very automated — but that doesn't mean your character isn't part of the equation.

That said, there are still community banks, microlenders, credit unions and other organizations dedicated to helping the local small business community, and in those cases, character may get you in the door. But you’ll still need to qualify for the loan.

This factor comes into play for many SBA loans where there are specific questions

Credit scores: The gatekeeper

Credit scores help lenders predict what you’re likely to do in the future based on what you’ve done in the past. Good credit scores indicate less risk. 

It is not unusual for lenders to use personal credit scores to determine if they will even consider your loan application. Not all lenders adhere to the same credit thresholds, but the better your personal scores, the more financing options you'll likely have.

Capacity: Your ability to repay

Capacity is the third C. No lender is interested in offering a loan to a business that doesn't have the ability to repay. This C focuses on revenue and cash flow. This is how they try to determine whether or not the borrower can repay a loan.

Even if you have great credit, if you don't have the revenue and cash flow to make periodic payments, your loan application will often be turned down. 

That's why idea-stage and early-stage startups have such a hard time getting business loans. If you don't have revenue that demonstrates the ability to make loan payments, you aren't going to successfully apply for a loan.

Some lenders will make loans to brand new businesses based on projections. When they do, it’s usually because the owners or principals of the business have experience or skills, combined with a very strong business plan.

Capital: Your investment in the business

Lenders often want to make sure you have invested your own money in the business (“skin in the game”), which makes it harder for you to walk away from your debts if business gets rough. Sometimes they will accept sweat equity instead of capital, but certain loans, including some SBA loans, may require that you have invested your own funds.

A healthy cash flow, and maybe even some capital set aside, tells a lender that you aren't looking for a last-ditch bailout loan to keep your business alive for a few months longer. 

Remember, lenders don't like risk.

Collateral: Security for the loan

The last C, collateral, may or may not be important, depending on the type of financing and lender policies. Traditional lenders like banks, credit unions, and the SBA, often require collateral, which may include real estate or equipment. 

Other lenders might consider your accounts receivable, your credit card receipts, or unspecified business assets as security for the loan. Although these things might not be called collateral, they tend to serve the same purpose, so maybe the last C could be "security," but that doesn't start with C.

Many lenders, especially traditional lenders, often require a personal guarantee. That means you’re personally responsible for paying back the loan if your business doesn’t.

Understanding your credit score based on the 5 C’s

You may have heard of the FICO^® score factors; the main factors that go into FICO’s consumer credit score calculation. Turns out, there are five of those too:

1. Payment history
2. Debt
3. Credit age
4. Credit mix
5. Inquiries/new credit

While those five factors don’t map directly to each of the 5 Cs, there is a connection. 

Take character, for example: payment history can be a proxy for this factor, since it shows a history of on-time payments. Debt utilization connects to capacity. Whether you have the capacity to pay back your debt depends, in part, on how much debt your business is already carrying.

How to use the 5 C’s to improve your credit

If you know what lenders may be looking for, you can evaluate your business' creditworthiness for yourself and fill in gaps you find before you apply for a loan.

Improving your character for lenders

Be prepared to talk about your credentials. How long have you been working in your industry, for example, may matter just as much as how long your business has been operating. If you have years of experience in the field, even if it's not as a business owner, it may help.

Consider creating a business plan if you don't have one. Even if your lender doesn't require it, being able to clearly articulate your plan will give you confidence and show credibility. A business plan also helps you create a strategic vision for your business and demonstrates that you've thought through the challenges and opportunities ahead.

Your management experience and industry knowledge signal to lenders that you understand your market and can handle the ups and downs of running a business.

Boosting your credit scores

You should know what your credit score is before you ever talk to a lender. There are dozens of ways to get your personal credit scores for free.

Most traditional lenders are looking for scores in the 700s, though they will sometimes go as low as 650–680. Most SBA lenders require scores no lower than around 650, or even 700, and some online lenders can offer financing if your personal credit scores are lower. But with lower scores, you’ll likely have fewer options, interest rates will often be higher, and you may get lower credit limits.

If you know your score before you apply, you can look for the type of financing you will more likely be approved for and take the steps needed to improve your scores. Check your credit reports for errors and dispute any inaccuracies. Try to pay down balances and pay on time going forward.

Enhancing your business's capacity

You may not be able to change what your revenues are or what your cash flow looks like overnight, but you can make sure you have your bookkeeping up to date. Potential lenders need access to all the information they may need to make a loan decision.

Make sure your bookkeeping is current and accurate. If your financial records are disorganized or incomplete, it raises red flags about your management capabilities. Consider working with a bookkeeper or accountant to ensure your financial statements tell a clear story of your business's performance.

Building your business capital

Stay on top of your cash flow. Poor cash flow management will not only make it more difficult to get a small business loan, it could threaten the survival of your business.

Lenders are looking for a healthy stream of cash flowing into your business every month, ideally from multiple sources. If you are overly dependent on one or two customers it can potentially hurt your business loan application.

Build up your reserves when possible. Having capital set aside shows lenders you can weather unexpected challenges without defaulting on your loan. It demonstrates you have skin in the game and aren't looking for a bailout.

Understanding and leveraging collateral

If you have assets that can serve as collateral, prepare a detailed list before you apply to streamline the process. Include equipment, real estate, inventory, or other business assets that have value.

Understand that regardless of whether or not you have collateral or the type of loan you choose, you will likely need to sign a personal guarantee. Be prepared for this requirement — it's standard practice in small business lending.

The bottom line: the 5 Cs of credit

When you understand the 5 Cs of credit, you’re no longer filling out a loan application guessing what lenders care about most. Character, credit, capacity, capital, and collateral all work together to answer the same big questions: Can you repay the loan, will you repay it, and what happens if things don’t go as planned? 

By addressing each of the 5 Cs, you’ll be better prepared to present a strong, credible case for financing.

Frequently asked questions