What are the Five Cs of Credit?
The five Cs of credit is a system used by lenders to gauge 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 five Cs of credit are character, capacity, capital, collateral and conditions.
The Five C's of Credit
Breaking Down the Five Cs of Credit
The five-Cs-of-credit method of evaluating a borrower incorporates both qualitative and quantitative measures. Lenders may look at a borrower's credit reports, credit scores, income statements and other documents relevant to the borrower's financial situation, and they also consider information about the loan itself.
Dann Ryan, CFP®
Sincerus Advisory, New York, NY
Understanding the Five Cs is critical to your ability to access credit and do it at the lowest cost. Delinquency in just one area can dramatically affect the credit you get offered. If you find that you are denied access to credit or only offered it at exorbitant rates, you can use your knowledge of the Five Cs to do something about it. Work on improving your credit score, save up for a larger down payment, or pay off some of your outstanding debt.
Sometimes called credit history, the first C refers to a borrower's reputation or track record for repaying debts. This information appears on the borrower's credit reports. Generated by the three major 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 repaid loans on time. These reports also contain information on collection accounts and bankruptcies, and they retain most information for seven to 10 years. (Note: Lenders may also review a lien and judgments report, such as LexisNexis RiskView, in order to further assess a borrower's risk prior to issuing a new loan approval.)
Information from these reports helps lenders evaluate the borrower's credit risk. For example, FICO, (formerly known as the Fair Isaac Corporation), a leading credit evaluation firm, uses the information found on a consumer's credit report to create a credit score, a tool lenders use for a quick snapshot of creditworthiness before looking at credit reports. FICO scores range from 300-850 and are designed to help lenders predict the likelihood that an applicant will be 90 or more days late on any reported credit obligation within the next 24 months.
Many lenders have a minimum credit score requirement before an applicant can be eligible for a new loan approval. Minimum credit score requirements will vary from lender to lender and from one loan product to the next. The general rule is the higher a borrower's credit scores, the higher the likelihood of receiving an approval. Lenders also regularly rely upon credit scores as a means for setting the rates and terms of loans. The result is often more attractive loan offers for borrowers who have good-to-excellent credit. Other firms, such as Vantage, a scoring system created by the collaboration of Experian, Equifax and TransUnion, also provide information to lenders.
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 together 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.
It is worth noting that sometimes lenders are prohibited from issuing loans to consumers with higher DTIs as well. Qualifying for a new mortgage, for example, typically requires a borrower to have a DTI of 43% or lower to ensure that the borrower can comfortably afford the monthly payments for the new loan, according to the Consumer Financial Protection Bureau. In addition to examining income, lenders look at the length of time an applicant has been employed at his current job and future job stability.
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 place a down payment on a home, for example, typically find it easier to receive a mortgage. Even special mortgages designed to make home ownership accessible to more people, such as loans guaranteed by the Federal Housing Authority (FHA) and the U.S. Department of Veterans Affairs (VA), require borrowers to put down between 2% and 3.5% on their homes. Down payments indicate the borrower's level of seriousness, which can make lenders more comfortable in extending credit.
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. With mortgage loans, for example, a down payment of 20% or more should help a borrower avoid the requirement to purchase additional private mortgage insurance (PMI).
Collateral can help a borrower secure loans. It gives the lender the assurance that if the borrower defaults on the loan, the lender can repossess the collateral. Car loans, for instance, are secured by cars, and mortgages are secured by homes. Collateral-backed loans, sometimes referred to as secured loans, 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 conditions of the loan, such as its interest rate and 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.