6 C's of Commercial Business Mortgage Credit

Capacity | Capital | Collateral | Conditions | Character | Commercial Loans Debt Ratios
Commercial loan lenders are in business to make money. Consequently, when a commercial loan lender lends money it wants to ensure that it will be paid back. The commercial loan lender must consider the 6 "C's" of Credit each time it makes a loan.

Capacity

Capacity to repay is the most critical of the five factors. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships - personal and commercial - is considered an indicator of future payment performance. Prospective lenders also will want to know about your contingent sources of repayment.

Capital

Capital is the money you personally have invested in the business and is an indication of how much you will lose should the business fail. Prospective lenders and investors will expect you to contribute your own assets and to undertake personal financial risk to establish the business before asking them to commit any funding. If you have a significant personal investment in the business you are more likely to do everything in your power to make the business successful.

Collateral

Collateral or guarantees are additional forms of security you can provide the lender. If the business cannot repay its loan, the bank wants to know there is a second source of repayment. Assets such as equipment, buildings, accounts receivable, and in some cases, inventory, are considered possible sources of repayment if they are sold by the bank for cash. Both business and personal assets can be sources of collateral for a loan. A guarantee, on the other hand, is just that - someone else signs a guarantee document promising to repay the loan if you can't. Some lenders may require such a guarantee in addition to collateral as security for a loan.

Conditions

Conditions focus on the intended purpose of the loan. Will the money be used for working capital, additional equipment, or inventory? The lender will also consider the local economic climate and conditions both within your industry and in other industries that could affect your business.

Character

Character is the personal impression you make on the potential lender or investor. The lender decides subjectively whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be reviewed. The quality of your references and the background and experience of your employees will also be considered.
Commercial Loans Debt Ratios
When analyzing the personal budget of a borrower, lenders use two different debt ratios to determine if the borrower can afford his obligations. These two debt ratios are:
  1. Top Debt Ratio
  2. Bottom Debt Ratio
The "top" debt ratio is defined as: Top Debt Ratio = Monthly Housing Expense/Gross Monthly Income By "monthly housing expense" we mean either the borrower's monthly rent payments, or if he/she owns a home, the total of the following:
  • 1st mortgage payment on home
  • Real estate taxes (annual cost/12)
  • Fire insurance (annual cost/12)
  • Homeowner's association dues (if the home is a condo or townhouse)
  • Second mortgage payment (if any)
  • Third mortgage payment (if any)
You will often hear the term “PITI.It refers to (P)rincipal, (I)nterest, (T)axes and (I)nsurance. While PITI is not exactly the same as Monthly Housing Expense because it does not include homeowner's association dues, the two terms are often used interchangeably. Lenders have learned over the years that a borrower's "top" debt ratio should not exceed 25%. In other words, a person's housing expense should not exceed 1/4 of his income. While lenders will often stretch this number to as high as 28%, traditional lending theory maintains that anyone with a debt ratio in excess of 25% stands a good chance of developing budget problems. The second ratio that lenders use to determine if a borrower can afford his/her obligations is the "bottom" debt ratio. It is defined as follows: Bottom Debt Ratio = (Total Housing Expense + Debt Payments) / Gross Monthly Income The only difference between the two ratios is the inclusion in the numerator of "debt payments." Debt payments include the following:
  • Car payments
  • Charge card payments
  • Payments on installment loans, for example - a payment on a washer & dryer that the borrower purchased
  • Payments on personal loans, for example, a signature loan from the borrower's bank.
What is not included in "debt payments" is Utilities such as APS, water or telephone and payments on real estate loans. Real estate loans are usually offset first by the net rental income from the property. If the borrower has a net positive cash flow from all his rentals, then the net income is usually added to his "gross monthly income." If the borrower has a net negative cash flow from all of his rental properties, then the amount of the negative cash flow is usually added to the numerator of the "bottom" debt ratio as if it were a monthly debt obligation, like a car payment. Traditional lending theory maintains that a borrower's "bottom" debt ratio should not exceed 33 1/3%. In other words, the total of the borrower's housing expense and debt obligations should not exceed 1/3 of his income. Lenders often will stretch on this ratio to as high as 36%, and some have even been known to stretch as high as 40% or more. Obviously a loan with a debt ratio of 40% is a far more risky loan than a loan with a debt ratio of 32%. .