Help Client's Understand the 5 Cs of Credit

The 5 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 5 Cs of credit are character, capacity, capital, collateral, and conditions.

Understanding the 5 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. They also consider information about the loan itself.

Each lender has its own method for analyzing a borrower's creditworthiness but the use of the 5 Cs—character, capacity, capital, collateral, and conditions—is common for both individual and business credit applications.

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1. 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. 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.1 Information from these reports helps lenders evaluate the borrower's credit risk. For example, FICO 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 to 850 and are designed to help lenders predict the likelihood that an applicant will repay a loan on time.2 Other firms, such as Vantage, a scoring system created by a collaboration of Experian, Equifax, and TransUnion, also provide information to lenders.3

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 from one loan product to the next. The general rule is the higher a borrower's credit score, the higher the likelihood of being approved.

Lenders also regularly rely on credit scores to set the rates and terms of loans. The result is often more attractive loan offers for borrowers who have good-to-excellent credit. Given how crucial a good credit score and credit reports are to secure a loan, it's worth considering one of the best credit monitoring services to ensure this information stays safe.

Improving Your 5 Cs: Character

Prospective borrowers should ensure credit history is correct and accurate on their credit report. Adverse, incorrect discrepancies can be detrimental to your credit history and credit score. Consider implementing automatic payments on recurring billings to ensure future obligations are paid on time. Paying monthly recurring debts and building a history of on-time payments helps build your credit score.

2. 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. 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 (CFPB).4

Improving Your 5 Cs: Capacity

Capacity comes down to how much money you make and how much debt you have. You can improve your capacity by increasing your salary or wages. Be mindful that a lender will likely want to see a history of stable income. Although switching jobs may result in higher pay, the lender may want to ensure your job security is stable and your pay will continue to be consistent.

Lenders may consider incorporating freelance, gig, or other supplemental income. However, income must often be stable and recurring for maximum consideration and benefit. Unpredictable, varying wages may be out of your control (i.e. you have no say on the number of hours worked in a given week); seeking more stable income streams may improve your capacity.

Regarding debt, paying down balances will continue to improve your capacity. Refinancing debt to lower interest rates or lower monthly payments may temporarily alleviate pressure your debt-to-income metrics, though these new loans may cost more in the long run. Be mindful that lenders may often be more interested in monthly payment obligations as opposed to full debt balances; therefore, paying off an entire loan and eliminating that monthly obligation will improve your capacity.

3. 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.

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.67 Down payments indicate the borrower's level of seriousness, which can make lenders more comfortable 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).

Improving Your 5 Cs: Capital

Capital is often obtained over time, and it might take a bit more patience to build up a larger down payment on a major purchase. Depending on your purchasing timeline, it may be advisable to ensure your down payment savings are yielding growth through a high-interest savings account. Some investors with a long investment horizon may consider placing their capital in index funds or ETFs for potential growth at the risk of loss of capital.

Another consideration is the timing of the major purchase. It may be more advantageous to move forward with a major purchase at a lower down payment as opposed to waiting to build capital. In many situations, the value of the asset may appreciate (i.e., housing prices on the rise), yielding minimum benefit to having more capital that may be equal to or less than the proportion of debt you would have previously incurred. 

4. 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.

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.

Improving Your 5 Cs: Collateral

You may improve your collateral by simply entering into a specific type of loan agreement. A lender will often place a lien on specific types of assets to ensure that they have the right to recover value in the event of your default. This collateral agreement may occur naturally as a requirement for your loan.

Some other types of loans may require external collateral. For example, private, personal loans may require placing your car as collateral. For these types of loans, ensure you have assets you can post, and remember that the bank is only entitled to ownership of these assets in the event of your default on the loan. 

5. Conditions

In addition to examining income, lenders look at the general conditions relating to the loan. This may include the length of time an applicant has been employed at their current job, how their industry is performing, and future job stability.

The conditions of the loan, such as the 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. To read more click here.