Your credit plays a key role in your ability to secure a loan, land an apartment, and even get approved for a cell phone, or utility contract. In fact, if you’re a business owner looking to fund a renovation, repair or a new business venture, you’ll need to prove your creditworthiness using more than just your credit.
More specifically, there are “5 C’s of credit” – or “characteristics” – that many traditional lenders use to assess potential borrowers.
What Are The 5C’s Of Credit?
The 5C’s of credit include Character, Capacity, Capital, Conditions and 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.
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.
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 credit report. Your credit report 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 capability of being able to handle a loan.
As you may have guessed, “capacity” refers to your actual ability to make your loan payments. Obviously, 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?
Your capacity is assessed by your income, assets, cash flow and other financial factors that can impact your ability to repay the loan. 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.
Lenders may also assess capacity through the following factors:
- DTI – Your lender will also want to know what your debts are like in order to calculate your debt-to-income ratio (DTI), 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.
In order to assess your capacity, your lender may want to see proof of income and employment. They may also want to look at your tax returns, bank statements, and pay stubs.
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 invested in their own ventures because it shows that they’re serious. To put it simply, they’d like to know how much money are you putting towards the loan. For example, if you’re looking to get a mortgage, the amount you put towards the down payment would show lenders how serious you are as a borrower.
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 considered “secured” because they both come with valuable collateral that the lender can repossess if the borrower defaults on loan payments.
How Does Offering Collateral Help The Borrower?
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.
The reason is, that when you provide collateral, it reduces the lender’s risk as they’ll have some recourse if you are unable to keep up with loan payments. As such, lenders will use your collateral (if provided) when assessing your creditworthiness.
The last “C” involves the conditions of the market that influence your loan. This C is out of your hands, and instead involves things that are out of your control, including interest rates, and industry trends (if it’s a business loan). If you’re buying a home and taking out a mortgage, conditions may also involve the cost of living and the number of homes that are listed for sale in your area.
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.
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 month instead of once a month.
Does credit usage influence your credit scores?
What do the 5C’s stand for?
Which of the 5Cs is the most important?
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 follow the above advice and you should have no trouble getting approved for the loan you need.