Lenders want to know that you can pay back the money you borrow. This means that you know how to manage debt responsibly or, said another way, that you are creditworthy. Using the 5 Cs of credit, lenders can evaluate your creditworthiness. So, what are the 5 Cs of credit?
In this post, we explain the 5 Cs of credit and how they may help a lender understand if you qualify for credit. Here’s what you need to know.
The first C of credit is character. In a credit sense, character refers to your credit history and credit references. This gives a lender a sense of how you have managed prior debt. When you begin using credit, lenders often report account history to credit bureaus. Credit bureaus share the history of your credit usage and payment record in documents called credit reports. Then, the bureaus use algorithms, like FICO and VantageScore, to calculate your credit scores.
Credit scores together with your credit history in your credit report provide lenders with the information required to determine your credit character. When referencing this information, lenders will look for details like a clean record of on-time payment history, borrowing patterns, types of credit you use, and prior foreclosures, bankruptcies, or other public records.
Some lenders set a minimum eligible credit score requirement before agreeing to make a loan or open an account. Usually, a higher credit score improves your chances of demonstrating strong credit character and less risk for the lender. Keeping a good credit score or improving your credit score with tools like rent reporting may help you qualify for more credit in the future.
The second C of credit is capacity. Your credit capacity refers to your general ability to repay the money you borrow based on your existing debts and income. One of the most common ways that lenders evaluate your credit capacity is by measuring the ratio of your debt-to-income, often called DTI.
To calculate DTI, add up all your monthly debt payments and divide that number by your total monthly income. Then, multiple that number by 100. For example, imagine that you have $500 in credit card and auto loan payments each month and no other monthly debt payments. Imagine you also earn $5,000 in monthly total income for this example. To calculate your DTI, you would divide $500 by $5,000 and multiply by 100 to get 10% DTI.
$500 / $5,000 = 0.10
0.10 x 100 = 10% Debt-to-Income
Lenders generally prefer to see a low DTI ratio. A low DTI ratio signifies less risk for the lender because of a potential borrower’s greater capacity to take on an additional monthly debt payment. The Consumer Financial Protection Bureau recommends maintaining a DTI ratio for all debts less than or equal to 36%.
The third C of credit is capital. Capital refers to all your money and assets that you could use to repay any money you borrow. Capital can also refer to any contribution you make alongside the money you borrow when you make a purchase or investment. For example, making a down payment on a car alongside using credit from an auto loan, or putting a down payment on a house that you also finance with a mortgage.
Capital allows you as a borrower to demonstrate your commitment to paying down a debt alongside your capacity. Often, household income is the primary source for paying down debt. However, any unexpected expenses or emergencies might eat into your normal monthly budget. If you have other income sources, investments, or other assets, then you may be able to absorb the temporary increase in your expenses without any issues. Lenders generally view customers with more capital as less risky.
The fourth C of credit is collateral. Collateral refers to any assets that you can pledge as security in exchange for credit. For example, a lender making an auto loan often requires that you pledge the vehicle being purchased as security. If you fail to pay back the loan as agreed, the lender can repossess the vehicle to recover the lost value from the debt you fail to pay. Other examples of collateral include assets like real estate, investments in stocks or bonds, cash, or equipment.
Typically, lenders refer to types of credit with collateral as secured loans or secured accounts. Common types of secured loans include auto loans, mortgages, or business loans and common types of secured accounts include secured credit cards or home equity lines of credit. Generally, secured loans and secured credit accounts are less risky for lenders and can benefit people new to credit by pledging assets in the place of demonstrating credit history.
The fifth C of credit is conditions. Conditions can refer to the specific circumstances or more general context of any request for credit. Lenders might consider, for example, how you plan to use the funds from a loan. For example, lenders may be willing to lend more money for a specific purpose, like buying an asset with value such as a car or home. Or, more generally, lenders might consider larger economic factors like government interest rates and market trends. You may or may not be able to control conditions. However, conditions do impact the overall risk for lenders.
The 5 Cs of credit help lenders assess risk and determine creditworthiness. Risk levels and creditworthiness impact how much money you might be able to borrow and what interest rate you may need to pay for the credit. A clear understanding of the 5 Cs cold help you learn how to improve your creditworthiness and overall financial health.