What is character-based lending?

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• 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 2021 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 empower underserved communities to reclaim control. 

What is character-based lending?

People often say a person's character says a lot about them, and that is no different in the world of lending. 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."

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. 

1. 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.
2. 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.
3. 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. 
4. 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 odds since lenders consider you a less risky borrower. 
5. 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. 

Example of how character-based lending works

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, Colorado Lending Source (CLS) — now known as B:Side Fund — an economic development organization based in Denver, Colorado, 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: CLS asks applicants with businesses less than two years old to go through a "Pre-Application Review" conducted by a Small Business Support Officer who'll 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 CLS 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. 

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. 

Character-based lending frequently asked questions

Is a character-based loan based on collateral?

While character-based loans are not based on physical collateral, like a house or car, you are borrowing against your reputation and your relationship with the lender.

How does character factor into a lending decision?

Character defines your reputation as a borrower, which traditional lenders quantify using your credit score.

Why is character-based lending important?

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. Character-based lending offers an alternative to traditional credit scoring algorithms.