The C's and P's of Credit Risk Analysis
By New York Institute of Finance
By New York Institute of Finance
Everyone knows that lenders look at your credit score when you apply for a loan, but did you know that’s not all they look at? Lenders will also rate the likelihood of a potential borrower defaulting by using a credit analysis concept known as the Five Cs and the Five Ps. These ten characteristics help lenders determine the overall risk of the loan.
The Five C’s
Conditions refer to the borrower’s intended purpose for the loan as well as the current economic climate. The borrower needs to state a specific purpose for how the loan will be used. The lender must take into consideration interest rates and business factors that could impact repayment of the loan.
Collateral is used by a borrower to guarantee the loan. If a borrower cannot repay the loan, the bank has security in this second source for repayment. Typical items used for collateral including buildings, equipment, cars, homes, and other high-value possessions. If the borrower defaults, the lender takes possession of the collateral as payment for the loan.
Character is where credit history come into play. This is where the bank looks at a borrower’s personal and financial background. Current and past information about loans, credit, and a person’s timeliness in repayment is examined. Credit scores give lenders a snapshot of person’s character.
Capacity and Cash Flow
Capacity and Cash Flow measures the borrower’s ability to pay back the loan. Here, lenders look at the debt to income ratio (DTI) to understand exactly how the loan will be repaid. This is often considered the most important factor in determining credit risk.
Capital is the borrower’s investment in the purpose of the loan. The more a borrower contributes means less of a chance for default. Capital is calculated by subtracting a borrower’s liabilities from assets.
The Five P’s
The Purpose of the loan should be explained in detail by the borrower. The lender needs to know exactly how the money will be used. For example, if the loan is for home improvements, the borrow should include a description of the exact renovations covered by the loan.
Payment includes all of the means that a borrower will use to repay the loan. This shows the bank how they will recover the loan as well as the interest. It often includes a borrower’s income as well as insurance policies.
Protection refers to something the borrower pledges to the bank as a guarantee that the loan will be repaid. If the borrower fails to repay the loan as it is defined, the loan is considered in default, and the bank can take possession of the collateral as payment.
People broadly covers a person’s credit history and qualities in relation to financial obligations. Lenders consider whether a person has a reputation for honesty and timeliness with financial obligations.
Perspective is a description of how the loan will be managed. It includes the bank’s plan to monitor the loan and their exit strategy in case of default.
The Five C’s and Five P’s are used by professionals in the financial industry to accept and reject loans. As regulators and finance professionals are becoming increasingly concerned about managing risk, it is important to understand the details of credit risk analysis.
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