First, let me thank Zach for inviting me to write for his website. Secondly, allow me to introduce myself. My name is Lucas Jones. I am sure if you are reading this, you have seen my name come up on Zach’s Facebook from time to time or on this site. Some of you are friends of mine as well. So, I may be no stranger. I am a loud conservative. I am not shy about it nor am I ashamed of it. I was and still am a big fan of Donald Trump. But that is not what defines me. I am also a husband and a father. I hold down a full-time job a credit officer at a small community bank in Texas County that also has a commercial production office in St. Louis. I am on my children’s school board. I am many things; and I cannot know for sure, but I am certain that when Zach asked me to write on his site, he likely thought I would come out trying to “own the libs” as some people like to say. But no. I am here to today to write about something that effects all of us — credit.
Here is what I mean by credit- going to the bank and getting a loan. That simple. Most of us have gotten an auto loan or a mortgage or maybe even a credit card (be responsible, please). But for banks, its more complicated than that. A banker’s number one job is to protect the banks assets. From the teller to the CEO an employee is charged with making sure assets are protected. Personal loans, auto loans, and mortgages are all fine and dandy and banks certainly make some income from these types on loans. But banks derive upwards of 70% or more of their annual income from commercial loans. These loans include investment properties (1-4 family housing, apartments, storage units, strip malls etc), Commercial Real Estate (gas stations, motels, hotels, restaurants, grocery stores), Operating Lines of Credit, Acquisition and Development loans, Commercial and Industrial loans, and for the rural audience, these types of loans can include agriculture real estate, livestock loans, equipment loans, and ag lines of credit.
A banker’s number one job is to protect the banks assets.
And that is what I would like to address today. I mentioned earlier that I am a credit officer. Much of my job in the credit administration department at my bank is doing credit analysis work on financials. But I also have experience in originating loans. There are too many scenarios and variables to get too specific on any one type of loan. So, I am going to explain, and hope to educate many of you on what it means from the bank’s side when you have a loan request and what we are looking at.
When reviewing a request for a loan, banks consider the “5 C’s of Credit”. They are and I will address each, character, capacity, collateral, capital, and conditions.
The 5 C’s of Credit
Character- credit behavior based on your credit report and score and your repayment history.
J.P. Morgan once said “Lending is not based primarily on money and property. NO sir, the first thing is character.” What the legendary banker means is that someone of high character will find a way to pay the bank back the money they have borrowed. Whether it be successfully change operations, take on another job or project for additional sources of cash flow to repay, or work in good faith to close the loan, liquidate collateral, and pay off the note. Today, when reviewing the borrower and/or guarantor (if the commercial loan is in your business name you will likely be asked to personally guarantee the loan) banks check credit reports first thing. This is very important to the bank because there are several things that can kill a deal before it is even started. If you are actively in a bankruptcy, federal tax liens, large judgements, foreclosures, repossessions, collections, and charge-offs can all kill a deal. Now, each one carries differing weights of negativity. Maybe your score has been impacted by student loans or medical collections, okay some bankers will overlook that if you have solid mortgage or installment repayment history. Collections and charge-offs can be addressed. Usually, bankruptcies and federal tax liens will end the deal right there.
Credit Reporting
Each year in the United States you are entitled to ONE FREE COPY of your credit report from the three nationwide credit reporting bureaus. You can order online at annualcreditreport.com or call 1-877-322-8228. I encourage you to utilize this and review your credit reports. You can remedy any derogatory lines you have such as getting current and paying your charge-off and collections; many of these places will work with you on a repayment plan and could even reduce the amount you owed (be forewarned however, if they reduce your outstanding balance, this will count as income on your tax returns and you will have to pay taxes on it).
Take pride in your credit score, improve it. Pay on time and what you agree too. Good credit opens doors!
Capacity- repayment ability (cash flow analysis)
Banks will generally ask you for your three most recent years of tax returns, if you own a business, you will need share the tax returns for it/them as well. If you own four different tax filing businesses, you will need them too. Banks will generally have you fill out a personal financial statement as well declaring all your assets and your liabilities to determine your net worth. Many banks do not report commercial loans to the credit bureaus, nor does John Deere and a select few other businesses that offer in-house financing. The PFS will allow the lender to include these debts in their net worth and cash flow analysis’. It is important to be honest on the PFS as banks are allowing you a great level of trust to initiate a relationship.
Analysis put these numbers in spreads and make adjustments to determine cash flow. Albeit a business return, a schedule C, E, or F, depreciation, interest, and amortization are not cash expenses and are added back to the net income. One-time expenses and non-recurring capital gains and losses or often adjusting. Banks are trying to determine the flow of cash you have and will compare that to your current debt and the proposed debt to see if you have capacity to repayment. Debt Service Coverage Ratio (DSCSR) vary from bank to bank or industry to industry per the individual banks loan policy, generally you need a DSCR of 1.20X for the bank to feel comfortable. Remember, despite your current debts and the proposed debt, you have to have money to live on as well!
Collateral- An asset (usually real estate, equipment, or livestock) you pledge to back the loan
Collateral is most likely going to include whatever it is you are borrowing for. If it is a farm, then the bank will take a 1st DOT on it. Equipment and livestock will have a UCC filed on it. Other forms of collateral include cash, CD’s, stocks, bonds, life insurance. Just about anything can be used for collateral. Now, the catch is, most banks will generally lend only 75-85% of the purchase price or value (whichever is lower) on the collateral, if there is a collateral shortfall, you will either need to offer more or inject cash…..
Capital- Down payment, equity injection, etc.
Capital is a broad term that means any thing that confers value or benefit to its owner. Cash is capital. Land is capital. Machinery and equipment are capital. If you have $10,000 in your account, well you have $10,000 in cash capital. In terms of getting a loan, banks like to see you have skin in the game. If you are purchasing a tractor for your farm and it costs $50,000, the bank’s credit policy says they can finance 80% of it, loan amount will be $40,000 and you will need $10,000 in cash to complete the purchase.
There is, of course, other ways to inject capital. If you own 5 acres free and clear from liens and its value can cover, you’re the down payment, the bank could take a 1st deed of trust on that 5 acres and issue you the full loan request. Rarely will a bank finance the full amount of a request. Exceptions can be made but be ready to be asked to put some skin in the game. (There are resources available from the government that can help with people who cannot afford a large down payment. Small Business Administration and the USDA are two governmental entities that may be of interest to anyone who is short)
Conditions- Market analysis and trends
Banks must look what the market says and the trends they see within it to help determine if this loan is smart. After all, a bank and a borrower are partners. If you are wanting $300,000 to start a newspaper, the market trend is clear- newspaper are struggling, they are shutting down nationwide, or being acquired by a few large multi-media companies and then being stripped down. This is just not a good investment for a bank. One the riskier businesses banks partner with is restaurants, who have a famously high historic failure rate.
Of course, there are good investments as well. Storage units have one of the lowest default rates in the country. Funeral homes, as grim as it may seem, usually repay, as people always have and always will pass away and the need will be there. In this case though, if you live in a rural area and there is already a funeral home, the market may indicate that two funeral homes are not sustainable. Therefore, market analysis is always important. And you can find it in every industry. For farmers- we review trends in beef sales (I know beef prices dropped during the beginning of the pandemic, yes they have recovered some, no, the farmer is not going to tell you they are ever happy with the market price lol).
Summary
Character, Capacity, Capital, Collateral, and Conditions are the basis of bankers when determining risk. If everything adds up the loan request will be on fast track for approval. However, a few other tips. If you are starting a business, develop a business plan, make a three year projection of revenue and expenses, be reasonable. Research. Be detailed. Be open to feedback, criticism, and creative ideas from your banker as well. I know of a banker who had a potential client who wanted to start a laundry mat. Laundry mats are not sexy loans. If you can’t repay your loan, what is a bank going to do with dozens of commercial size washer and dryers? He asked the potential borrower to put his house up as collateral to get this loan. The potential borrower declined and was offended. But here is the rub from the bankers’ eyes- if you don’t believe in your business enough to put your house up as collateral then why would the bank want to partner with you?
Taking on commercial or agriculture debt can be terrifying. But hopefully with this blog post you have a better understanding how the bank works when these requests come in. There is so much more to each additional loan but with this understanding you will have a head start if you find yourself dreaming and take the step forward. You will know what where you stand with your 5 C’s before you head to the bank. Your banker will be impressed!
