Lending is inherently risky, even when a borrower’s credit history and financial status indicate they will maintain their payment schedule throughout the life of their loan. To help minimize risk and protect against loss due to defaulting borrowers, lenders must have robust credit risk mitigation strategies in place.
About Credit Risk Mitigation
In lending, borrowers, whether another company or an individual, are expected to pay back the principal amount and all accruing interest during the life of the loan. Without comprehensive protections in place, the lender can lose a significant amount of the loan should a borrower default on payments.
Lending companies can use numerous tactics known as credit risk mitigation to shield themselves from loss. These practices are designed to minimize the probability of the borrower defaulting on their loan and causing the lender to lose part or all of their investment.
One common and effective strategy lenders use is analyzing the 5 Cs of Credit.
The Five Cs of Credit
Lenders often focus on the five Cs of credit when analyzing an applicant to determine if they can be trusted to pay back their loan in full. Not all five are necessary for all loan types, but each one can help evaluate an applicant, and some or all can combine to form a complete understanding of an applicant’s risk levels.
The five Cs lenders can look at are:
Capacity shows whether the person applying for the loan has the financial resources to repay it. Capacity looks at things like the applicant’s current income, expenses, cash flow, credit score, and more to determine the applicant’s debt-to-income ratio (DTI). Doing so shows the maximum loan amount the applicant can handle with their current finances and helps determine if they can keep up with payments for every billing cycle.
The DTI formula calculates the applicant’s debt as a percentage of their income. If the DTI percentage is low, the applicant will likely be approved. However, a high DTI can indicate too much risk and result in a denied loan application.
Capital is the amount of funding the applicant is able and willing to put toward the loan. Otherwise referred to as the down payment on sales purchases, capital shows how invested the applicant is in their own loan. The more money an applicant puts down for their loan, the less risky the loan will seem to be for the lender because it shows that the applicant is contributing more significantly to the loan. A higher down payment means there is more for the borrower to lose should something go sideways at some point in the life of the loan. A borrower is more likely to do what is needed to save the loan than risk losing their invested capital.
Character involves analyzing the applicant’s history, including their employment history, personal credit history, and more. Lenders can even evaluate how well or poorly an applicant pays their bills. Do they tend to pay on time, or are they typically submitting late payments? Whatever the results are, character helps paint a picture for the lender to show whether the applicant can be trusted to repay their loan.
Collateral is the alternative source(s) of payment that can be used to repay the loan. Collateral is the asset (or assets) an applicant can pledge to the lender to ensure the lender will be financially protected should the borrower default on their loan at some point. Collateral is evaluated by its monetary value and ease of liquidation, and it should be of equal value to the loan amount. Forms of collateral can include equipment, automobiles, houses, and more. Unsecured loans do not feature collateral, but secured loans like mortgages, home equity loans, auto loans, and certain business loans do.
Conditions refer to the overall terms of the loan and outside economic conditions that could affect the applicant’s ability to repay the loan. More commonly applied to business loans, conditions evaluate the current economic climate and forecasted changes in the business’s industry. Conditions can also assess the “why” for the loan—why does the borrower need this money, and what will it be used for? Answers to these questions can vary from “building expansion” to “debt consolidation,” “home renovations,” and more.
What Are the Outcomes of Analyzing the 5 Cs?
When a business or individual applies for a loan, the lender will look at some or all of these factors to decide whether to approve or deny the application. Through careful analysis with the help of quality loan origination software, lenders can evaluate the 5 Cs and determine the risk levels of each application.
If the outcomes of the 5 C analysis show the applicant to be too high of a risk, the lender can choose to deny the application, preventing the process from moving forward. If the analysis shows that the applicant has good creditworthiness and comes with a low level of risk, chances are the lender will approve the application and move forward to the loan origination phase.
Lenders who want extra protection when it comes to risk mitigation should rely on absVision from Allied Business Systems.
absVision is advanced lending software with robust capabilities to help your company analyze applicants and mitigate financial risk during the life of your loans. Discover more about our risk mitigation capabilities by speaking with an ABS expert today: 800-727-7534