What Are the Five C’s of Credit?
The five C’s of credit is a system used by lenders to gauge the creditworthiness of potential borrowers. The system weighs five characteristics of the borrower and conditions of the loan, attempting to estimate the chance of default and, consequently, the risk of a financial loss for the lender. But what are these five C’s? The five C’s of credit are character, capacity, capital, collateral, and conditions.
- The five C’s of credit are used to convey the creditworthiness of potential borrowers.
- The first C is character—the applicant’s credit history.
- The second C is capacity—the applicant’s debt-to-income ratio.
- The third C is capital—the amount of money an applicant has.
- The fourth C is collateral—an asset that can back or act as security for the loan.
- The fifth C is conditions—the purpose of the loan, the amount involved, and prevailing interest rates.
Understanding the Five C’s of Credit
The five-C’s-of-credit method of evaluating a borrower incorporates both qualitative and quantitative measures. Lenders may look at a borrower’s credit reports, credit scores, income statements, and other documents relevant to the borrower’s financial situation. They also consider information about the loan itself.
Each lender has its own method for analyzing a borrower’s creditworthiness but the use of the five C’s—character, capacity, capital, collateral, and conditions—is common for both individual and business credit applications.
Although it’s called character, the first C more specifically refers to credit history, which is a borrower’s reputation or track record for repaying debts. This information appears on the borrower’s credit reports. Generated by the three major credit bureaus (Experian, TransUnion, and Equifax), credit reports contain detailed information about how much an applicant has borrowed in the past and whether they have repaid loans on time. These reports also contain information on collection accounts and bankruptcies, and they retain most information for seven to 10 years.
Information from these reports helps lenders evaluate the borrower’s credit risk. For example, FICO uses the information found on a consumer’s credit report to create a credit score, a tool lenders use for a quick snapshot of creditworthiness before looking at credit reports. FICO scores range from 300 to 850 and are designed to help lenders predict the likelihood that an applicant will repay a loan on time.
Other firms, such as Vantage, a scoring system created by a collaboration of Experian, Equifax, and TransUnion, also provide information to lenders.
Many lenders have a minimum credit score requirement before an applicant is approved for a new loan. Minimum credit score requirements generally vary from lender to lender and from one loan product to the next. The general rule is the higher a borrower’s credit score, the higher the likelihood of being approved. Lenders also regularly rely on credit scores to set the rates and terms of loans. The result is often more attractive loan offers for borrowers who have good-to-excellent credit.
Given how crucial a good credit score and credit reports are to secure a loan, it’s worth considering one of the best credit monitoring services to ensure this information stays safe.
Lenders may also review a lien and judgments report, such as LexisNexis RiskView, to further assess a borrower’s risk before they issue a new loan approval.
Capacity measures the borrower’s ability to repay a loan by comparing income against recurring debts and assessing the borrower’s debt-to-income (DTI) ratio. Lenders calculate DTI by adding a borrower’s total monthly debt payments and dividing that by the borrower’s gross monthly income. The lower an applicant’s DTI, the better the chance of qualifying for a new loan. Every lender is different, but many lenders prefer an applicant’s DTI to be around 35% or less before approving an application for new financing.
It is worth noting that sometimes lenders are prohibited from issuing loans to consumers with higher DTIs as well. Qualifying for a new mortgage, for example, typically requires a borrower to have a DTI of 43% or lower to ensure that the borrower can comfortably afford the monthly payments for the new loan, according to the Consumer Financial Protection Bureau (CFPB).
Lenders also consider any capital the borrower puts toward a potential investment. A large contribution by the borrower decreases the chance of default. Borrowers who can put a down payment on a home, for example, typically find it easier to receive a mortgage. Even special mortgages designed to make homeownership accessible to more people, such as loans guaranteed by the Federal Housing Administration (FHA) and the U.S. Department of Veterans Affairs (VA), may require borrowers to put down 3.5% or higher on their homes. Down payments indicate the borrower’s level of seriousness, which can make lenders more comfortable extending credit.
Down payment size can also affect the rates and terms of a borrower’s loan. Generally speaking, larger down payments result in better rates and terms. With mortgage loans, for example, a down payment of 20% or more should help a borrower avoid the requirement to purchase additional private mortgage insurance (PMI).
Dann Ryan, CFP®, Sincerus Advisory, New York, NY
Understanding the Five Cs is critical to your ability to access credit and do it at the lowest cost. Delinquency in just one area can dramatically affect the credit you get offered. If you find that you are denied access to credit or only offered it at exorbitant rates, you can use your knowledge of the Five Cs to do something about it. Work on improving your credit score, save up for a larger down payment, or pay off some of your outstanding debt.
Collateral can help a borrower secure loans. It gives the lender the assurance that if the borrower defaults on the loan, the lender can get something back by repossessing the collateral. The collateral is often the object one is borrowing the money for: Auto loans, for instance, are secured by cars, and mortgages are secured by homes.
For this reason, collateral-backed loans are sometimes referred to as secured loans or secured debt. They are generally considered to be less risky for lenders to issue. As a result, loans that are secured by some form of collateral are commonly offered with lower interest rates and better terms compared to other unsecured forms of financing.
In addition to examining income, lenders look at the length of time an applicant has been employed at their current job and future job stability.
The conditions of the loan, such as the interest rate and amount of principal, influence the lender’s desire to finance the borrower. Conditions can refer to how a borrower intends to use the money. Consider a borrower who applies for a car loan or a home improvement loan. A lender may be more likely to approve those loans because of their specific purpose, rather than a signature loan, which could be used for anything. Additionally, lenders may consider conditions that are outside of the borrower’s control, such as the state of the economy, industry trends, or pending legislative changes.
What Are the 5 C’s of Credit?
The 5 C’s of credit are character, capacity, collateral, capital, and conditions.
Why Are the 5 C’s Important?
Lenders use the five C’s to decide whether a loan applicant is eligible for credit and to determine related interest rates and credit limits. They help determine the riskiness of a borrower or the likelihood that the loan’s principal and interest will be repaid in a full and timely manner.
Is There a 6th C of Credit?
People sometimes refer to the credit score or credit report as the sixth C of credit.
View more information: https://www.investopedia.com/terms/f/five-c-credit.asp