Five Cs Of Credit
The 5 Cs of credit are location, location, location.
Wait, no, that’s not right. Those are the three rules of real estate. Let’s try that again.
The 5 Cs of credit are character, capacity, capital, collateral, and conditions, and they are what guide lenders on whether or not they should loan us money. Let’s see about those Cs…
“Character” is less about our personal charisma and more about our financial reputation. Do we pay our bills? Do we pay them on time? Are we now or have we previously been bankrupt? Are there any tax liens against us? Basically, if someone were to judge us solely on our financial history, would we look like a good person?
“Capacity” looks at how much we make and how much we owe, and tries to figure out if we can afford to pay back the loan we’re trying to get.
“Capital” is how much of our own money we can fork over toward whatever we’re trying to finance. For example, if we’re trying to buy a house, we’re more likely to get a loan if we can put down a 20% down payment versus only putting down a 10% down payment.
“Collateral” is stuff that we own that we can put up against a loan. Like...let’s say we’re trying to buy a vacation house in the Florida Keys. In order to secure the home loan, we put our house in Denver up for collateral. This means that, if we default on the Keys loan, the bank can get what we owe them from the value of our Colorado house.
And last but not least, certain “conditions” might come into play. Are we taking out a loan to add a garage onto our house, or are we just borrowing money for vague and unspecific purposes? Are we trying to grow a business that impeding regulations might shut down completely within the next year? Is the economy in general about to tank, making it less likely we’ll be able to repay the loan?
On the one hand, this can seem like a lot of stuff to keep track of. But on the other, we guess it’s nice to know that lenders are trying to get a big-picture view of our financial situation before they support—or crush—our financial dreams.
Related or Semi-related Video
Finance: What is a Line of Credit?133 Views
finance a la shmoop what is a line of credit? oh I'll definitely pay it back. [ man talks to camera]
yeah, that's a line of credit, but it's just a line like can I buy you a drink
or do you come here often or I bet my mother would love you, in financial real
life a line of credit or LOC if you just like using acronyms to make yourself
seem are keenly smart, is deb,t or rather an LOC is an option to take on debt. why [man in front of power point]
would somebody want an option to take on debt? well here's why.
yep companies can't ordain their futures. they don't know what's coming .but paying
a few bucks today for financial life insurance tomorrow is usually a really
good idea because the skies are not always sunny all day. so a company that [robot assembly line]
makes shoelace tying robots might be doing great today but there's a big fat
product release coming and they have no idea if it'll do well right away or take
three years to catch on. or you know rip people's feet off well who knows, maybe
people will actually be able to tie their own shoelaces by then. what do you
think America? how are we doing but yeah it's unpredictable this sort of thing [man sits on a couch]
happens to tech companies all the time. so while the company doesn't need cash
today they may need it in the future .so they pay a bank or lender a small token
amount in return for that lender guaranteeing that the money will be
there at a set price in rent and set terms at some point in a defined future.
ie the next three years or something like that. that is, you know prevailing
rates or five percent they might pay half a percent to guarantee they can
borrow it 10 million dollars at 5% but, we'll get into. that all right if a [smiling man on the phone]
company does in fact decide to exercise its option to draw down cash from its
line of credit or rather to get the bank to wire the cash they have reserved into
the company's own bank account then usually it just starts paying interest
or rent on the money the day it's borrowed, just like it would have if it
borrowed money at the outset. well why wouldn't a company just borrow money
today and have it stuffed under its mattresses? [woman holds a stash of cash]
well because almost always the option to draw down money costs a fraction of the
interest it would cost to actually borrow the money itself. so we have a
company who wants the right to borrow ten million bucks and
they're willing to pay half a percent per year for a guarantee to be able to
borrow that money I'd say five percent per year when or if they borrow it. if
they never borrow it that half a percentage is wasted. [definitions on the screen]
well the half a percent line of credit option fee is 50 grand a year and let's
say two years go by in the company doesn't need the money.
they've just wasted that fifty grand a year each year. but then they borrow all
of it in year three and guess what in those three years interest rates went up
two percent 3 percent four percent something like. that yeah it could happen.
so the company paid 100 grand for the option to borrow the money at five [equations ]
percent interest, and yes that hundred grand is a lot of dough ,but compare it
with the cost of borrowing had the company borrowed all ten million right
away. well had they done that they would have paid five percent per year in
interest on that ten million bucks or five hundred grand a year and that's
times two years .so it would have cost them a million dollars in interest had
they borrowed all the money right away. instead miserly wiserly, they only [man scribbles with a pen]
paid a hundred grand for the option for two years because they didn't need the
money right away and that line of credit structure saved them nine hundred
thousand dollars in borrowing costs. a nice job mr. CFO. so why isn't it free to [thumbs up]
just reserve a line of credit with a bank? like why do they charge anything
when they're not actually loaning out money today? well the bank has to
allocate gets finite resources to accommodate that line of credit drawdown.
sure enough Murphy's Law happens at work and the company will want to exercise
the LOC and draw down the money from the bank at just the worst time in history [woman frowns in front of a bank vault]
like say in the middle of 2008 or 9, when nobody had anything right. okay.
well banks have tightly regulated laws or covenants around which they can
borrow money from the Fed or the government at say 2%, then mark it up to
4% and lend it out. and they make money on that spread right? so if the bank had
tons of LOCs out there it could be bad news if they weren't charging a little [hands reach for cash]
something for them. and no a credit card essentially is a line of credit you fill
out a bunch of forms swear and then pinkie swear to pay back the money .if a
month goes by and you don't pay back the money you owe well then you
get charged enormous rates for borrowing. it but if you do pay it back, the rates
are really low maybe you have a small annual fee although most credit cards,
they don't even have those anymore. but more directly, the fee is paid by the merchant
ie the earring store that sold you the seven belly button rings for forty bucks. [ pierced and tattooed woman holds document]
each in the form of a transaction fee that is, the $280 you would have spent on
a constellation for your stomach, the merchant paid the credit card company
about 1% or 280 for managing the bank in that transaction. what about as much as
you're gonna be spending on cotton swabs and antibacterial soa.p I hope you
weren't planning on wearing a tube top anytime soon. anyway that's a line of
credit .use it wisely. it can bite you [woman with red stomach grimaces]
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