What are the five Cs of credit? A guide
What are the five Cs of credit?
The Five Cs of Credit is a system used by lenders to assess the solvency potential borrowers. The system evaluates five characteristics of the borrower and the loan conditions, trying to estimate the probability of fault and, therefore, the risk of financial loss for the lender. But what are these five Cs? The five Cs of credit are character, capacity, capital, collateral, and terms.
Key points to remember
- The Five Cs of Credit are used by lenders to assess the creditworthiness of potential borrowers.
- The first C is character — the applicant’s credit history.
- The second C is the capacity, that is, the debt to income ratio of the applicant.
- The third C is capital — the amount of money a claimant has.
- The fourth C is collateral, an asset that can guarantee or secure the loan.
- The fifth C concerns the conditions: the purpose of the loan, the amount involved and the prevailing interest rates.
Understanding the Five Cs of Credit
The five C’s of credit method assessment of a borrower integrates both qualitative and quantitative measures. Lenders can view credit reports, credit scores, income statements, and other documents relating to the borrower’s financial condition. They also take into account information about the loan itself.
Each lender has their own method of analyzing a borrower’s creditworthiness, but the use of the five Cs (character, capacity, principal, collateral, and terms) is common for personal and business credit applications.
Although it is called character, the first C more specifically refers to credit history, which is a borrower’s reputation or history of debt repayment. This information appears on the borrower’s file credit reports. Generated by the big three 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 paid off their loans on time. These reports also contain information on collection accounts and bankruptcies, and they retain most of the information for seven to ten years.
The information in these reports helps lenders assess the credit risk. For example, FICO uses information found on a consumer’s credit report to create a credit score, a tool lenders use to get a quick overview 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 companies, such as Advantage, a rating system created by a collaboration of Experian, Equifax and TransUnion, also provides 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 loan product to loan product. The general rule is that the higher a borrower’s credit rating, the higher the likelihood of being approved. Lenders also routinely rely on credit scores for set the rates and conditions of loans. This often results in more attractive loan offers for borrowers with good to excellent credit.
Given the importance of a good credit score and good credit reports in securing a loan, it is worth considering one of the best credit monitoring services to ensure the security of this information.
Lenders can also consider a privilege and a judgment report, such as LexisNexis RiskView, to further assess a borrower’s risk before issuing a new loan approval.
Capacity measures the borrower’s ability to repay a loan by comparing income to recurring debts and the borrower’s assessment debt / income (DTI) report. Lenders calculate DTI by adding up a borrower’s total monthly debt payments and dividing it by the borrower’s gross monthly income. The lower an applicant’s DTI, the better the chances 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 should be noted that sometimes lenders are prohibited from granting loans to consumers with higher DTIs. Eligibility for a new mortgage, for example, typically requires a borrower to have an DTI of 43% or less to ensure that the borrower can comfortably afford the monthly payments on the new loan, depending on the Consumer Financial Protection Bureau (CFPB).
Lenders also take into account any capital that the borrower invests in a potential investment. A large borrower contribution decreases the risk of default. Borrowers who can put down a down payment on a house, for example, generally find it easier to get a mortgage. Even special mortgages designed to make home ownership more accessible to more people, such as mortgage backed loans. Federal Housing Administration (FHA) and the US Department of Veterans Affairs (VA), oblige borrowers to deposit between 2% and 3.5% on their home. Down payments indicate the seriousness of the borrower, which can make lenders more comfortable extending credit.
Deposit size can also affect a borrower’s loan rates and terms. Generally speaking, larger down payments translate to better rates and terms. In the case of mortgages, for example, a down payment of 20% or more should help a borrower avoid having to buy private mortgage insurance (PMI).
Dann Ryan, CFP® Sincere advice, New York, New York State
Understanding the Five Cs is essential for your ability to access and afford credit affordably. Single-area delinquency can drastically affect the credit offered to you. If you find that you are being denied access to credit or offered it only at exorbitant rates, you can use your knowledge of the Five Cs to do something. Work on improving your credit score, save for a bigger down payment, or pay off some of your outstanding debt.
Collateral can help a borrower get loans. It gives the lender the assurance that if the borrower defaults on the loan, the lender can get something back by taking back the collateral. Collateral is often the object for which we borrow money: auto loans, for example, are secured by cars and mortgages are secured by houses.
For this reason, collateral-backed loans are sometimes referred to as secured secured loans or debts. They are generally considered to be less risky for lenders to issue. As a result, loans secured by some form of collateral are usually offered with lower interest rates and better terms compared to other forms of unsecured finance.
In addition to looking at income, lenders look at how long a candidate has worked in their current job and the stability of their future job.
The terms of the loan, such as the interest rate and the amount of main, influence the lender’s desire to finance the borrower. Terms can refer to how a borrower intends to use the money. Take the example of a borrower applying for a car loan or a home improvement loan. A lender may be more likely to approve these loans because of their specific purpose, rather than a signature loan, which could be used for anything. Additionally, lenders can take into account conditions that are beyond the borrower’s control, such as the state of the economy, industry trends, or pending legislative changes.
What are the 5 Cs of credit?
The 5 Cs of credit are character, capacity, collateral, capital and conditions.
Why are they important?
Lenders use the Five Cs to decide whether a loan applicant is eligible for credit and to determine interest rates and related credit limits. They help determine a borrower’s risk level or the likelihood that the principal and interest on the loan will be repaid in full and on time.
Is there a 6th C of credit?
People sometimes refer to the credit report as the sixth C of credit.