Your credit profile plays a key role in your ability to secure a loan, land an apartment, and even get a job. Lenders will review your credit before extending a loan. More specifically, there are “5 C’s of credit” – or “characteristics” – that many traditional lenders use to assess potential borrowers.
Key Points
- The 5 C’s of credit include character, capacity, capital, conditions, and collateral.
- Lenders may consider the 5 C’s when assessing loan applications.
- Getting familiar with the 5 C’s may help you improve your credit score, reduce your debt, and save for a bigger down payment.
What Are The 5C’s Of Credit?
The 5C’s of credit include the following:
- Character
- Capacity
- Capital
- Conditions
- Collateral
The 5C’s are a framework used by lenders to evaluate the creditworthiness of borrowers, particularly small businesses looking to borrow money.
Lenders will assess the borrower’s creditworthiness using these 5 characteristics. However, the weight attributed to each of the 5C’s will vary based on the lender.
Snapshot: 5 C’s Of Credit
| Factor | Definition | Factors Considered | Importance |
| Character | Borrower’s trustworthiness & history of paying debts | – Credit score & history – References – Reputation | Indicates the likelihood of timely loan payments |
| Capacity | Borrower’s ability to repay the loan based on income and financial obligations | – Debt-to-Income (DTI) ratio – Employment history – Income and expenses | Indicates whether the borrower can handle the loan payments along with current bills |
| Capital | Borrower’s personal stake in the transaction | – Down payment – Investments – Savings- Liquid assets | Shows the borrower’s financial commitment to the transaction |
| Collateral | Valuable assets used as security for the loan | – Value of property or assets – Loan-to-value (LTV) ratio | Provides the lender with a safety net in case the borrower defaults |
| Conditions | External factors impacting loan approval | – Loan purpose – Economic environment – Interest rates – Loan term | Helps assess the risk impacted by external market and economic conditions that could affect loan success |
1. Character
Your character is an important factor when it comes to whether or not a lender will approve you for a loan. Your character basically comes down to how trustworthy, credible, and responsible you are with your finances. More specifically, it refers to how likely you are to repay your debts.
How Does A Lender Assess Your Character?
Lenders use your references, credentials, and reputation among previous lenders to assess your character, as they only want to deal with borrowers who are able of keeping their credit commitments.
These days, your character is measured through your business credit score and credit report, which features all sorts of important credit information such as the types of loans you’ve had and your credit history. Lenders will use this information when assessing your ability to handle a loan.
2. Capacity
Capacity refers to your actual ability to make your loan payments. A lender won’t want to loan out any funds to someone who they believe doesn’t have the capacity to make the payments.
When you take out a loan, you’ll have to repay it in full by a specific date. But if you’re not able to make your installments, the lender will be left trying to recoup their losses.
How Does A Lender Assess Your Capacity?
Ideally, lenders like to deal with borrowers who have a steady, full-time job and make a decent income that allows them to have the funds needed to cover their loan payments after all other debt obligations have been satisfied.
Your capacity is assessed by the following:
- Income – Your regular earnings will determine how much you have to cover your loan payments. As such, lenders will want to review your income to ensure you’re financially capable of handling your bills.
- Assets – Valuable assets can serve as collateral for a loan. This reduces the lender’s risk in the event that you no longer make payments, as they can seize the collateral if you default on the loan.
- Cash Flow – If you’re taking out a business loan, your lender may want to see what your cash flow situation is like. Cash flow is a critical factor in determining your ability to secure a loan because it shows your lender that you have a consistent source of income to cover loan repayments.
- Debt-To-Income Ratio – Your lender will also want to know what your debts are like in order to calculate your DTI ratio, which is basically a measure of your income as it relates to paying your current debt. If your DTI is too high, that means your income might not be adequate enough to cover an additional loan payment.
- Income Stability – Your lender will not only want to ensure you have enough funds to cover the loan, but that you will be able to cover it for the length of the loan. As such, they’ll also look at how stable your income is.
3. Capital
When a lender is assessing your capital, they’re referring to the amount of money you have invested into your own project or investment. Lenders like to see borrowers with a larger stake in the transaction.
How Does A Lender Assess Your Capital?
Lenders will look at factors such as the following to assess your capital:
- Down payment
- Savings
- Investments
- Liquid assets
For example, if you’re looking to get a mortgage, a higher down payment would show lenders that you’re a more serious and capable borrower.
4. Collateral
Collateral refers to any valuable asset that is used to back a loan. For instance, a car loan is collateralized by the car, and a mortgage is collateralized by the home. In both of these cases, the loans are secured because they’re both backed by valuable collateral that the lender can seize and sell if the borrower defaults on the loan.
How Does A Lender Assess Your Collateral?
Lenders will look at the following to assess your collateral:
- Property value
- Value of vehicles and other tangible assets
- Loan-to-value ratio, which measures the loan amount relative to the value of the asset being purchased
As a borrower, you can offer collateral to help strengthen your loan application. Generally, when you offer collateral, your chances of approval increase, and you’re more likely to qualify for a lower interest rate.
5. Conditions
The last “C” involves the conditions of the market that influence your loan. Most factors in this category involve things that are out of your control, which we’ll get into next.
How Does A Lender Assess Conditions?
Lenders may assess the following conditions:
- Purpose of the loan (ie. home purchase, vehicle purchase, business expansion, etc)
- Economic conditions (ie. interest rates and market trends)
- Interest rates
- Cost of living
- Loan terms (repayment period, fixed or variable rate)
Reviewing conditions helps the lender understand how external factors could affect the success of the loan, and therefore the lender’s risk.
How To Improve Your 5C’s
If you’re looking to improve your 5C’s of credit to boost your creditworthiness, consider focusing on the following.
Make Your Payments On Time
This is always the number one piece of advice given when a consumer asks how to improve their credit, and for a good reason. Payment history is one of the largest contributing factors to the calculation of your credit scores (roughly 35%). Keeping up with payments and paying down any debt you have will likely improve your capacity, which lenders will see as positive.
Learn more: How Does Your Payment History Affect Your Credit Scores?
Double Down On Your Savings
Making sure you have a healthy nest egg is an important part of any financial plan. Having a savings account that you consistently contribute to looks good on paper, and lenders will appreciate that. It may also prove that you have the funds necessary for a down payment and to handle the costs associated with a loan.
Reduce Your Debts
The amount of debt you carry month to month has an effect on your credit scores. So, keeping up with those payments and even paying off your debts early may help improve your credit.
Plus, most lenders take into consideration how much debt you have. Too much can decrease your capacity to repay new debt.
Increase Your Credit Limits
If you regularly max out your credit cards, this could be hurting your ability to improve your credit scores. Maintaining a credit utilization ratio of less than 30% may help you improve your credit over time. One way you can achieve this is by asking for a credit limit increase.
This way, you can keep charging the same amount each month, but you won’t be using up your full credit limit. You can also consider paying off your balance twice monthly instead of once a month.
Bottom Line
If you’re in the market to apply for a loan or secure financing for a large purchase, then your credit scores will likely be taken into consideration. This is why checking your own credit is an important part of a healthy financial life. Keep on top of your credit health by following the above advice, and you should have little trouble getting approved for the loan you need.
