What They Are, How They’re Used, and which is Most Important
The 5Cs of credit are important because lenders use these factors to determine whether to approve you for a financial product. Lenders also use these 5 Cs, which are character, capacity, capital, collateral, and conditions, to set your loan rates and loan terms.
What Are the 5 Cs of Credit?
The 5 Cs 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. The 5 Cs of credit are character, capacity, capital, collateral, and conditions.
KEY NOTES
- The 5 Cs of credit are used to convey the creditworthiness of potential borrowers, starting with the applicant’s character, which is their credit history.
- Capacity is the applicant’s debt-to-income ratio.
- Capital is the amount of money an applicant has.
- Collateral is an asset that can back or act as security for the loan.
- Conditions are the purpose of the loan, the amount involved, and prevailing interest rates.
Understanding the 5 Cs of Credit
The five-Cs-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. Most lenders use the 5 Cs—character, capacity, capital, collateral, and conditions—when analyzing individual or business credit applications.
1. Character
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, which are 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.
2. Capacity
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.
3. Capital
Lenders also consider any capital the borrower puts toward a potential investment. A large capital 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.
4. Collateral
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.
5. Conditions
In addition to examining income, lenders look at the general conditions relating to the loan. This may include the length of time an applicant has been employed at their current job, how their industry is performing, 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. Business loans that may provide future cash flow may have better conditions than a house renovation during a slumping housing environment that the borrower has no intention of selling in.