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The five C’s of credit offer lenders a framework to evaluate a loan applicant’s creditworthiness—how worthy they are to receive new credit. By considering a borrower’s character, capacity to make payments, economic conditions and available capital and collateral, lenders can better understand the risk a borrower poses.
Luckily, you can take steps to address the five C’s before applying for a loan. We’ll walk you through each of the characteristics and how lenders evaluate them when vetting loan applicants.
What Are the 5 C’s of Credit?
The five C’s of credit describe a borrower’s creditworthiness based on their character, capacity to repay the loan, available capital, economic conditions and collateral. Banks and other financial institutions use these factors when making lending decisions, so it’s important to understand them before you apply for a loan.
1. Character
A lender will look at a mortgage applicant’s overall trustworthiness, personality and credibility to determine the borrower’s character. The purpose of this is to determine whether the applicant is responsible and likely to make on-time payments on loans and other debts. To evaluate a borrower’s character, lenders may look at an applicant’s credit history and past interactions with lenders. Likewise, they may consider the borrower’s work experience, references, credentials and overall reputation.
2. Capacity
Capacity summarizes a borrower’s ability to repay a loan based on the applicant’s available cash flow. When evaluating this element of credit, lenders consider whether the borrower can cover new loan payments on top of their existing debt service. Relevant factors include the borrower’s income and income stability. In the case of a business loan, a lender will also evaluate the business’s income.
3. Capital
Whether you’re applying for a business loan, mortgage or other loan, lenders want to see that you’re committed enough to contribute some of your own funds. In the case of a business loan, lenders evaluate the investments a borrower has made into the business, including inventory, equipment and a point of operations. For mortgages, auto loans and other major purchases, lenders look at the down payment size the borrower is committing to the purchase.
4. Conditions
In addition to evaluating a borrower’s personal finances, lenders look at other financial conditions like the overall health of the economy and specifics of the loan. This typically includes the loan interest rate, amount of principal and intended use of the loan proceeds. However, lenders also consider outside factors like the state of the economy as a whole, industry trends (in the case of a business loan) and other conditions that might impact loan repayment.
5. Collateral
Collateral is a valuable asset a borrower pledges to secure a lender’s interests in making the loan. If the borrower defaults on the loan, the lender can repossess or otherwise seize the asset to recoup the unpaid amount. A borrower’s ability—and willingness—to pledge valuable collateral reduces the risk to the lender.
For example, when taking out a mortgage, the real estate serves as the collateral; with an auto loan, the collateral is the car. Further, these are the most common types of collateral that lenders accept:
• Real estate
• Cars
• Cash or checking and savings account balances
• Certificates of deposit and other investments
• Business equipment and inventory
• Accounts receivable/unpaid invoices
How Banks and Lenders Use the 5 C’s of Credit
Banks and lenders use the five C’s of credit as a framework to evaluate a borrower’s creditworthiness. By reviewing the five characteristics, lenders can gain a comprehensive understanding of the borrower’s financial situation and the level of risk in lending the money.
Banks and other financial institutions evaluate these factors differently: some create and apply point systems that incorporate each element while others look at the five characteristics more flexibly.
For that reason, it’s necessary to understand the five C’s of credit before you apply for a loan. Personal loan prequalification can help you evaluate whether you’re likely to qualify, but understanding the five C’s can provide a deeper understanding of whether the approval is likely or not.
How to Improve on Each of the 5 C’s of Credit
Understanding the five C’s of credit can help you qualify for a loan, but you may need to spend time improving one or more elements. Here’s how you can improve your overall financial situation and bolster your creditworthiness by addressing the five C’s:
• Increase your savings. Increasing your savings can improve how your assets look on paper and illustrate that you can repay a loan. Depending on your savings goals, this strategy can also increase how much capital you have for a down payment.
• Make consistent, on-time bill payments. Payment history accounts for 35% of a consumer’s FICO Score calculation—the largest of any other category. On-time monthly payments can improve your credit score over time and demonstrate your good character to lenders. If you struggle to remember your loan payment schedule, consider automating payments so they’re subtracted directly from your bank account.
• Pay off debts early. The amount a borrower owes makes up 30% of their credit score. This means that making extra payments or paying off debts early can improve your credit score. By doing so, you also improve your capacity to repay the loan, thereby reducing the risk you pose to a lender.
• Wait to open other new accounts or credit cards. Borrowers who open multiple credit accounts in a short period of time are considered riskier than borrowers who do not. So, while it only accounts for 10% of a FICO Score calculation, any amount of new credit you take out can speak to your borrower character as well as your capacity to cover debt service.
• Request a credit limit increase. A credit utilization rate is the ratio of how much a borrower owes on revolving lines of credit to the overall credit limit. A ratio greater than 0% but below 30% is typically considered good. To improve your ratio, consider requesting a credit limit increase—just don’t take advantage of your new credit to make large purchases, as that will drive up your ratio.
Related: How To Build Credit
