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| Capacity | Capital | Collateral | Conditions | Character | Commercial
Loans Debt Ratios |
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| 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. |
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Capacity
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| 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. |
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Capital
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| 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. |
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Collateral
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| 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. |
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Conditions
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| 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. |
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Character
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| 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. |
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Commercial Loans Debt Ratios
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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:
- Top Debt Ratio
- 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%.
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