Whether you agree or disagree with President Biden’s Student Loan Forgiveness Plan, it is useful to think of it in relation to the usual ways that credit is granted, and the expected payback of loans. That is why we posted the “5 Cs of Credit,” one of the 74 essential concepts in Your Total Wealth. Because financial advisors and bankers have clients borrowing or lending money, those clients will appreciate the power and wisdom of the 5 Cs. Enjoy and share.
THE FIVE Cs of CREDIT
You’ve heard the lyric, “love makes the world go round.” In person-to-person relationships, that may be true. In terms of commerce, however, credit makes the world go around.
Like love, credit is based on a trusting relationship between two parties: The lender provides a good, service or loan to the borrower without immediate payment, trusting that payment will be received in the future.
Terms for granting the credit typically take the form of a written agreement between borrower and lender, allowing for a possible legal remedy if the payment is not received.
When lenders decide whether to provide the credit, they take five factors into account. These factors, which assess the likelihood of repayment, each begin with the letter C. They are called the Five Cs of Credit:
Character: What evidence supports the potential debtor’s trustworthiness, integrity and honesty? Credit score and personal recommendations are important considerations for this C.
Capacity: What is the potential debtor’s ability to repay the loan? Work history, cash flow and physical health are important considerations.
Capital: What is the debtor’s total net worth relative to the amount borrowed?
Collateral: What are the available assets to back up the loan? This C is more important for secured (collateralized) loans, (e.g., house, car) than for unsecured loans (e.g., credit card debt).
Conditions: What are the prevailing economic factors (inflation, interest rates, competition) affecting the decision?
Both lenders and borrowers take a risk when agreeing to a loan. The lender’s risk is that the loan may not be repaid, requiring time, energy, and possibly legal intervention. The borrower’s risk is that unforeseen factors may prevent repayment, setting the stage for a long-term debt burden and possibly bankruptcy. Whether you are the lender or the borrower, understand the meaning and implications of the Five C’s of Credit, and negotiate the loan accordingly.