- Character-based lending is an alternative to traditional credit scoring that focuses on reputation.
- Character-based lending seeks to remedy lending biases, particularly across business loans.
- You may find character-based loans from local Community Development Financial Institutions (CDFIs).
The most recent Report on Firms Owned by People of Color by the Federal Reserve Bank of New York found that Black- and Latino-owned firms that applied for non-emergency financing were less than half as likely as white-owned firms to be approved. What's more concerning is that this was the case even when these POC-owned firms presented low credit risk.
Character-based lending presents a solution to systemic credit discrimination and empowers underserved communities to reclaim control.
What is character credit?
Character-based lending is a unique type of loan evaluation method that focuses on assessing a borrower's character rather than relying solely on traditional metrics like credit scores, income, and collateral. In other words, character-based lending shifts the focus from financial criteria to an individual's integrity and character, which could lead to more racially equitable lending practices where credit scores fail.
As financial educator Chris Longworth notes, the character-based approach can be particularly valuable in small business lending. "It takes into account the prospect's status in the community," Longworth says. "It looks at their contributions to the community and how they positively or negatively impact the community and the other businesses around them."
Accessing funds can be a major hurdle for many small business borrowers, especially those who lack collateral or have faced intentional discrimination. Longworth suggests that character-based lending can be the solution needed to help borrowers overcome these challenges. Character-based lending benefits not only borrowers but lenders as well.
"Character-based lending can enhance lenders' presence in the community overall and provide jobs and services to the area it serves," Longworth says. "This can be very beneficial from a public relations standpoint for any lender."
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The five C's of credit
The five C's of credit refer to the key factors lenders consider when evaluating your creditworthiness: character, capacity, capital, collateral, and conditions. While no regulatory standard requires lenders to use this review process, most of them will still scrutinize your five C's before lending money to you. Here's what each means.
- Character: This refers to your reputation and track record as a borrower. While traditional lenders may assess your character by looking at your credit score and report, character-based lending values your ties to the community and your relationship with creditors.
- Capacity: Capacity is your ability to repay the loan. Lenders will analyze your income, employment status, debt-to-income ratio, and other financial assets to determine this.
- Capital: Capital pertains to your net worth or financial reserves, including savings and investment account balances. Lenders typically prefer borrowers with a lot of capital since it can be used to repay the loan should anything happen.
- Collateral: Collateral is the asset you offer to secure the loan. If you default on the loan, lenders can seize and sell the collateral to recover the loan amount. Having collateral can typically increase your loan approval chances since lenders consider you a less risky borrower.
- Conditions: These are factors like the loan's interest rate, amount, and purpose, which can all affect your ability to repay the loan.
As the name suggests, character-based lending primarily focuses on the 'Character' component of the five C's. Essentially, the lender trusts your goodwill rather than solely considering your credit score or assets.
Key aspects of character credit
The emphasis on financial metrics like credit scores excludes many worthy borrowers — especially in minority communities — from gaining access to the capital and opportunities they need to expand their businesses.
To combat this problem, B:Side Fund (formerly called Colorado Lending Source), an economic development organization based in Denver, developed a character-based loan program to provide startups and small business borrowers affordable capital they may not otherwise be able to obtain. Here's how their "character-based" underwriting process works:
- Pre-application review: The Fund asks applicants with businesses less than two years old to go through a "Pre-Application Review" conducted by a Small Business Support Officer who will review their business plan and monthly cash flow projections for the next two years.
- Complete loan application: If the applicant makes it through the pre-application review round, or if their business has been in existence for over two years, they'll then complete a loan application and submit financials for the business.
- Interview with an internal loan review committee: After completing the loan application, the borrower must attend a 30-minute interview with an internal loan review committee composed of Fund staff. If, after assessing the applicant's character and preparedness, the committee votes to move forward with the application, a loan officer will perform formal financial underwriting.
- Approval by external loan review committee: If the loan officer determines that the business venture is financially viable, they'll send the loan package to an external loan review committee composed of bankers, economic development professionals, and others for further review.
- Loan closing: Finally, if the external loan review committee approves the loan, funds will be transferred to the borrower after closing.
How lenders assess character credit
Lenders will do a customary financial review of your personal and business financials. That review can consist of the following:
- Credit score: Your credit score provides a quick report on how well you pay back your creditors, i.e., your creditworthiness.
- Credit reports: Your credit reports from the three major credit bureaus (Equifax, Experian, and TransUnion) will be reviewed.
- Application information: Lenders review the information on your loan or credit card application, including your income, employment, and residential history.
- Public records: There may also be a check for any public records that could indicate financial instability (e.g., bankruptcies, liens, judgments).
How to improve your character credit
- Pay bills on time: This is the most important part of building a positive credit history. A positive payment history of on-time payments will show potential lenders that you can be trusted with credit.
- Keep credit utilization low: Aim for a credit utilization ratio below 30%. Pay down debt to get there and keep the amount of debt you have as minimal as possible.
- Build a positive credit history: Establish a history of responsible borrowing and on-time repayment. This will not happen overnight. It takes time to build credit history.
- Monitor your credit report: Regularly check your credit report to catch errors early and dispute inaccuracies if necessary. You will also ensure that your payments are being reported properly. You should not have to pay for your credit report — access it for free at AnnualCreditReport.com.
Where to find character-based loan programs
If you're struggling to secure business financing through traditional banks, Community Development Financial Institutions (CDFIs) in your area may offer character-based loan programs to help you obtain the capital you need to expand your venture. These lenders aim to provide fair and responsible financing to underserved communities that traditional banks often overlook or discriminate against.
Non-profit organizations like MORTAR, Native Women Lead, and ConnectUP! Institute, can also be excellent resources for business owners looking for financial assistance.
Frequently asked questions about character-based lending
You can demonstrate good character to lenders by paying all bills on time and establishing a track record of borrowing money and on-time repayment to your creditors. Also, maintain a credit utilization ratio under 30% to build a good credit score.
Character can factor into a lending decision when borrowers use it to determine your reputation before deciding to loan you money. Character-based lending may be especially useful to startups and small businesses that have trouble qualifying for a loan through more traditional methods used by lenders, like a credit score.
Character-based lending is important because it offers an alternative to traditional credit scoring algorithms. Traditional credit scores provided by FICO and VantageScore have been criticized for reinforcing and increasing racial disparity, as Black and Hispanic consumers are more likely to have subprime credit scores or no credit score at all.
