6 Min Read | July 1, 2022
Lenders commonly use the five C’s of credit – character, capacity, capital, collateral, and conditions – to decide whether to extend credit to an individual.
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At-A-Glance
The five C’s of credit – namely, character, capacity, capital, collateral, and conditions – refers to a method lenders use to assess a potential borrower’s creditworthiness.
Lenders weigh these five qualitative and quantitative measures, ranging from FICO credit scores to credit history, when evaluating loan applications
While many facets of the five C’s are under an applicant’s control, some may be influenced by outside factors like the economy at large.
If you’re applying for a mortgage for the first time, thinking about getting a new credit card, or hoping to finance a family car, it may be time to learn about the five C’s of credit – a framework perhaps as fundamental to the lending world as the ABCs are to the English language.
What Are the Five C’s of Credit?
The five C’s of credit refer to:
- Character.
- Capacity.
- Capital.
- Collateral.
- Conditions.
These five categories incorporate qualitative and quantitative measures, allowing lenders to ascertain your personal (or business) creditworthiness and decide whether you’re a good candidate for shouldering more debt.1 While every lender has a different approach to making that determination – not all use the five C’s, for instance – the more you know about this method, the better you can understand what lenders look for. And the more you know, the better you can prepare yourself as a potential borrower – and boost your chances of landing that crucial financing when needed.
Why the Five C’s of Credit Matter
The five C’s of credit approach allows lenders to more accurately measure how great a credit risk a potential borrower might pose, such as how likely it is that they’ll default on that loan, mortgage, or credit card.
Financial indicators, such as credit reports, credit scores, income statements, and loan terms, can all signal whether an applicant is creditworthy. Lenders may go about analyzing personal or business applications in different ways, but a borrower’s creditworthiness typically boils down to character, capacity, capital, collateral, and conditions.
Here’s a closer look at what each of the five C’s of credit means and how understanding this method can help you put your best foot forward for lenders.
Character: How Lenders Evaluate Trustworthiness and Credibility
The dictionary definition of “character” pertains to the mental and moral qualities distinct to an individual. It’s not so different in the world of credit, where it refers to your credibility, reliability, and reputation. Can you be counted on to make on-time payments toward your credit card bills, car loan, or long-term mortgage?
A borrower’s credit history, which appears on credit reports generated by the three major credit bureaus – Experian, TransUnion, and Equifax – spells out that critical intel. Here’s what lenders may find when they look under the hood:
Credit scores. FICO and VantageScore, the two most common credit scoring models, glean credit information, such as whether you pay your bills on time, to create a three-digit credit score ranging from 300 to 850. The higher the credit score, the more attractive a borrower is to lenders, and the better your loan terms may be.2
Credit scores can vary depending on a lender’s questions or priorities. For example, Experian and Equifax share 16 FICO credit score versions with lenders, while TransUnion provides 21, and FICO itself has over 50 iterations, sometimes resulting in different scores for a credit card application than one for a mortgage or car loan.
Credit history. Your past is very much alive on your credit record. For example, information about a lawsuit or judgment against you can be reported for up to seven years; bankruptcies can appear on a report for up to 10 years; and unpaid tax liens remain for 15 years. Conversely, positive credit information – such as a history of on-time payments – is also reported. These favorable traits benefit your credit “character.”
Capacity: Why Lenders Care About Cash Flow
Capacity refers to an applicant’s financial bandwidth – is there enough cash flow to ensure that the loan will be repaid in full? To find out, lenders may scrutinize aspects like a borrower’s income, income stability, and whether an increased loan payment will be a burden on top of existing debt.
One way to calculate capacity is to determine a potential borrower’s debt-to-income ratio (DTI), which is calculated by adding up monthly debt payments and dividing that figure by gross monthly income. While a higher credit score reflects positively on your character, a lower DTI signals the capacity to shoulder more debt, increasing the likelihood of loan approval or consideration. A higher DTI may indicate that the borrower can’t meet their monthly payments.
Ideal DTI requirements may differ according to lender and borrowing purpose, but the Consumer Financial Protection Bureau (CFPB) suggests that many lenders prefer a potential borrower to maintain a DTI ratio of 36% or less for all debts.3
Capital: Down Payments Signify Commitment
For mortgages, car loans, and other major purchases, applicants can increase their chances of approval by putting down a sizable down payment. By contributing your own capital, lenders can see that a borrower takes the investment seriously – and a large contribution can reduce the risk of default. Down payment size can also affect your borrowing costs over the life of the loan. For instance, the higher the down payment, the less you’ll need to borrow. This can lead to lower minimum monthly payments and less interest paid over time.
For some lending options, down payment requirements may be influenced by credit score. Government-backed FHA mortgage loans, for example, require qualified first-time and return buyers with a FICO score of at least 580 to make a down payment of at least 3.5%, while those with FICO scores of 500–579 need to put down 10%.4
Collateral: Your Pledge to Commitment
Even if you have no intention of defaulting on a loan, your lender may need additional assurance that you won’t be a credit risk. That’s where collateral comes in. When you pledge the very asset that you’re attempting to finance, like a car or home, the lender knows that they can repossess the collateral to get their money back, if necessary.
Lenders tend to view collateral-backed loans, also known as secured loans, as less risky than unsecured loans, which require no collateral. Secured loans may offer lower interest rates and better financing terms than unsecured loans, and are often easier to get for individuals with thin or poor credit history.5
Conditions: External Influences to Consider
While your personal finances take center stage in a lender’s evaluation of a credit application, there are other factors, or conditions, that come under review. Lenders may consider the loan interest rate, amount of principal, and how the money will be used. They may also evaluate conditions that the borrower has no influence over, such as the state of the economy, since any widescale changes or trends can figure into loan repayment.
The Takeaway
The five C’s of credit is the yardstick some lenders use to measure a potential borrower’s creditworthiness. By gauging each of the C’s – character, capacity, capital, collateral, and conditions – lenders can better determine whether an applicant is a credit risk. Credit history, cash flow, debt-to-income ratio, length of employment, and even the current economy are some of the qualitative and quantitative measures that may be considered before a mortgage, credit card, or auto loan is approved.
1 “Understand The 5 C’s Of Credit Before Applying For A Loan,” Forbes
2 “Credit Scoring: FICO, VantageScore & Other Models,” Debt.org
3 “Debt-to-income calculator,” Consumer Financial Protection Bureau
4 “FHA Down Payment Requirements for Homebuyers,” FHA.com
5 “Differentiating between secured and unsecured loans,” Consumer Financial Protection Bureau
Randi Gollin is a freelance writer and editor who’s covered topics including food trends, shopping, and cyber issues for digital publications and tech and media brands.
All Credit Intelcontent is written by freelance authors and commissioned and paid for by American Express.
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