The Five C’s of Credit

Each lender has its own method for analyzing a borrower’s creditworthiness. Most lenders use the five Cs—character, capacity, capital, collateral, and conditions—when analyzing individual or business credit applications.

1. Character

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, which are generated by the three major credit bureaus: Equifax, Experian, and TransUnion. 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. Information from these reports helps lenders evaluate the borrower’s credit risk.1 For example, FICO uses the information found on a consumer’s credit report to create a credit score, a tool that 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 VantageScore, a scoring system created by a collaboration of Equifax, Experian, 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 that this information stays safe.

Improving Your 5 Cs: Character

Prospective borrowers should ensure that 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 help to 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.4

Every lender is different, but many lenders prefer an applicant’s DTI to be around 36% 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.

For example, qualifying for a new mortgage typically requires a borrower 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).5

Improving Your 5 Cs: Capacity

You can improve your capacity by increasing your salary or wages or decreasing debt. 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 that your job security is stable and that 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. Securing 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 on 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 than in full debt balances. So, paying off an entire loan and eliminating that monthly obligation will improve your capacity.

3. Capital

Lenders also consider any capital that the borrower puts toward a potential investment. A large capital 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. For instance, loans guaranteed by the Federal Housing Administration (FHA) may require a down payment of 3.5% or higher and 90% loans by the U.S. Department of Veterans Affairs (VA) don’t require a down payment at all.78 Capital contributions indicate the borrower’s level of investment, which can make lenders more comfortable about extending credit.

Down payment size can also affect the rates and terms of a borrower’s loan. Generally, larger down payments or larger capital contributions 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).9

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 time line, you may want to ensure that your down payment savings are yielding growth, such as through investments. Some investors with a long investment horizon may consider placing their capital in index funds or exchange-traded funds (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 with a lower down payment as opposed to waiting to build capital. In many situations, the value of the asset may appreciate (such as housing prices on the rise). In these cases, it would be less beneficial to spend time building capital.

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 for which one is borrowing the money: 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 losses in the event of your default. This collateral agreement may be 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 that you can post, and remember that the bank is only entitled to these assets if you default.

5. Conditions

In addition to examining income, lenders look at the general conditions relating to the loan. This may include the length of time that 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 the amount of principal, influence the lender’s desire to finance the borrower. Conditions can refer to how a borrower intends to use the money. Business loans that may provide future cash flow may have better conditions than a house renovation during a slumping housing environment in which the borrower has no intention of selling.

Additionally, lenders may consider conditions outside of the borrower’s control, such as the state of the economy, industry trends, or pending legislative changes. For companies trying to secure a loan, these uncontrollable conditions may be the prospects of key suppliers or customer financial security in the coming years.

Improving Your 5 Cs: Conditions

Conditions are the least likely of the five Cs to be controllable. Many conditions such as macroeconomic, global, political, or broad financial circumstances may not pertain specifically to a borrower. Instead, they may be conditions that all borrowers may face.

A borrower may be able to control some conditions. Ensure that you have a strong, solid reason for incurring debt, and be able to show how your current financial position supports it. Businesses, for example, may need to demonstrate strong prospects and healthy financial projections.

The Bottom Line

Lenders use certain criteria to evaluate borrowers prior to issuing debt. The criteria often fall into several categories, which are collectively referred to as the five Cs. To ensure the best credit terms, lenders must consider their credit character, capacity to make payments, collateral on hand, capital available for up-front deposits, and conditions prevalent in the market.