The C’s of Credit
The five C's of credit is a system used by
lenders to measure 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 C’s of the Credit
Character
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.
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.
The C’s of the Credit
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.
The C’s of the Credit
Capital
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.
The C’s of the Credit
Capital
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.
The C’s of the Credit
Capital
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.
The C’s of the Credit
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.
The C’s of the Credit
Collateral
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.
The C’s of the Credit
The conditions of the loan, such as the interest rate and
Conditions 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.
The C’s of the Credit
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.
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