A:

The five C's of credit comprise a list of factors used by lenders to predict the probability of a borrower defaulting on a loan. The five factors are character, capacity, capital, collateral and conditions. A borrower's credit rating, on the other hand, is an overall assessment of his creditworthiness. Depending on the agency making the assessment, some or all of the five C's of credit may be used to calculate a borrower's credit rating.

Banks and finance companies are assiduous about assessing risk before agreeing to give a borrower a loan. They want as much assurance as possible that the potential income generated by the loan outweighs the risk of default. While there is no foolproof method for eliminating risk completely or ensuring that every borrower makes good on his agreement to repay his loan with interest, lenders have established several steps that they use with a high degree of success to determine whether to lend money to a potential borrower.

One such step is to evaluate several factors known to be strong indicators of a potential borrower's risk. The most common of these factors have been culled into a group known colloquially as the five Cs of credit. Character refers to the borrower's reputation with regard to financial matters, such as his track record of paying back debts on time in the past. Capacity is his ability to repay a loan, determined by his income compared to his other outstanding debts. Capital includes money the borrower puts toward an investment, thereby lowering his default risk by ensuring he has skin in the game. Collateral is the property pledged by the borrower to secure the loan. The loan's conditions, including its interest rate and repayment term, also influence the default risk.

Lenders use the five Cs in relation to one another when making credit decisions. A deficiency in one area can often be outweighed when a borrower is strong in another area. For example, a borrower with shaky character as evidenced by past defaults might still get a loan if he pledges hefty collateral.

Another step is evaluating the borrower's credit rating. The actual work of calculating a credit rating is usually farmed out to a credit reporting agency, which uses the five Cs of credit and other methods to assign a rating to a borrower. Agencies such as Moody's and Standard & Poor's rate government and commercial borrowers, while bureaus such as Equifax and Experian rate individual borrowers. Credit reporting agencies gather data about a potential borrower and then use proprietary algorithms to convert that data to a standardized scale that conveys creditworthiness.

For example, Standard & Poor's rates borrowers on a scale from AAA (excellent credit) to D (terrible credit). The major credit reporting agencies for individuals use numerical scores. Generally, a score in the 700s or higher signifies strong creditworthiness, a score in the 600s indicates moderate risk and a score below 600 denotes a high-risk borrower.

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