Lenders extend financial relief to borrowers that are credit-worthy. If you want to get approval for a loan, it’s critical to know how good and bad credit scores affect borrowing. The five Cs of credit determine whether you qualify to receive new loans or credit accounts. But what are the 5Cs of credit? Learn what factors lenders use to evaluate loan applicants below.
The 5 Cs of Credit
Many lenders refer to the five Cs of credit when making lending decisions. Suppose you want to improve your chances of getting decent loan terms. In that case, knowing what factors financial institutions use to understand your creditworthiness is crucial.
The 5 C’s of credit include the following:
- Character
- Capacity
- Capital
- Collateral
- Conditions
Character
A potential borrower’s character is one of the most important factors for loan qualification. Your credit report is a credible source that represents your character. Why? Your past financial history allows a lender to gauge your trustworthiness and credibility.
When you submit a loan application, your credit score will decrease by a few points due to a hard credit check. Hard credit checks allow financial institutions to view the information on your credit reports. Equifax, Experian, and TransUnion are the three main credit bureaus that collect and summarize your economic activity. Each credit reporting agency provides a credit report to authorized companies.
Credit reports show whether you have a good track record of paying your debts on time. Suppose you are forgetful and have previously made late payments. In that case, those late payments will be visible to lenders that pull your credit report. Late payments, collection accounts, and bankruptcies are signs of a high-risk borrower. They may make it more challenging to get emergency cash.
Capacity/Cash Flow
A borrower’s cash flow, or capacity, is their ability to pay back a loan according to the loan terms of a financial contract. An excellent way to measure financial capacity is to review your debt-to-income (DTI) ratio. A DTI demonstrates a borrower’s ability to manage debt payments in the form of a percentage.
To determine your DTI, add up all your monthly bills to get your total monthly debt, then divide the total by your gross monthly income. Your gross monthly income is the amount you earn before taxes and other deductions. The result is your debt-to-income ratio as a decimal.
Suppose your monthly debt payments amount to $1,600, and your gross monthly income is $4,000. You get 0.4 by dividing these numbers, which makes your debt-to-income ratio 40%. According to financial experts, your DTI should be lower than 35%. A high DTI signifies to lenders that you are a credit risk because you have too much outstanding debt compared to your household income.
Paying down your existing debt will improve your DTI and your personal credit history. You can use a debt payoff tracker to help you keep track of your financial progress and stay motivated. Obtaining a Tier 1 credit score will result in better loan terms, allowing you to save money.
Capital
Capital is your level of financial contribution. How much of your own money are you willing to invest? The financial institution wants to know you’re committed enough to decrease the odds of default. Capital sounds similar to collateral, but capital is the amount of money you have, while collateral is a security asset.
Suppose you are a small business owner and want to get a loan to help your business succeed. During the approval process for a business loan, the lender will evaluate your business revenue, inventory, equipment, etc., because these factors represent your cash flow.
You need to provide a down payment if you want to purchase a home. The expected monetary contribution is 20% of the property price. While you can give a smaller down payment, you may end up with a higher interest rate. High-interest rates make the borrowing process more expensive and stressful. The more value an asset has, the better your loan terms end up being.
Collateral
Collateral is a valuable asset that a borrower provides to a financial institution to offset the lending risk. In the event a borrower cannot keep making loan payments, the lender can seize the collateral to recoup the unpaid loan balance.
If you aim to get a business loan, mortgage, or auto loan, keep in mind that you need to provide some form of collateral. For example, lenders use the vehicle as collateral for auto loans to mitigate financial risk. Using collateral is also beneficial for borrowers because it increases the possibility of qualifying for a sizable loan despite the bad credit.
Using collateral offers some benefits, but there are also financial risks. You can lose possession of your home, car, savings, and other investments if you experience unexpected financial issues during the repayment process. Unsecured loans do not require the use of collateral, but the qualification requirements are typically more strict. However, there are loans for bad credit online that do not require collateral and offer flexible approval requirements.
Conditions
Conditions include the borrower’s financial situation and the economic conditions concerning the loan. Financial institutions evaluate a borrower’s income stability for approval and external economic factors. For example, a lender will consider federal interest rates, industry trends, and other conditions. The state of the economy affects everyone, even financial institutions.
Benefits of a Good Credit History
When you start working on improving your credit character, you gain a wealth of opportunities. A good credit rating can help you get farther in life because you save money and qualify for more favorable offers.
These are some benefits of building good credit:
- You can get lower insurance rates.
- Avoid paying a security deposit to get a new phone.
- The number of housing options available to you shoots up.
- You may end up looking better to potential employers.
- You may qualify for lower interest rates on credit cards and loans.
- You can spend more with a higher credit card limit.
How To Improve Your Credit Score
Knowing the five C’s of credit gives consumers the financial knowledge they need to improve credit scores. Working to improve your credit can make your life significantly more manageable because you end up getting better deals on financial exchanges.
Do you have a good credit score? Credit scores are split into five categories based on numerical ranges. Knowing how your credit score looks to financial institutions can help you better understand your credit position. If you know you have a low credit score, you can start looking into bad credit, and no credit check loan options.
FICO is one of the most commonly used credit scoring models. Here is how FICO defines credit score ranges:
- Poor — 300-579
- Fair — 580-669
- Good — 670-739
- Very Good — 740-799
- Excellent — 800-850
If your score is lower than 670, then you have fair or poor credit. These two credit score ranges are not viewed kindly by most lenders. But you can work on improving your credit by taking specific financial actions. Below are a few strategies to improve your credit score rating over time.
Pay Bills on Time
Your payment history is the single most important factor for credit score calculation. Your credit can increase through on-time payments and decrease as a result of late or missed payments. When debt payments are more than 30 days late, lenders will generally report them to the major credit bureaus, who then update your credit reports. Negative accounts on credit reports are red flags to lenders and can continue to affect your credit for months or years.
Ask For Higher Credit Limits
A credit limit determines how much you can spend and your credit utilization rate. Consumers who spend more than 30% of their available credit card balances display signs of being high-risk borrowers. Paying down your debt can help you build credit quickly. But you can also try asking your credit card issuer for a higher credit limit. A higher credit limit lowers your credit utilization rate and allows you to spend more money without affecting your score.
Become an Authorized User
An authorized user on a credit card shares a credit account with a family member or friend but doesn’t share financial responsibility. Suppose your friend has excellent credit due to smart credit card usage. You can build credit without making transactions if you get added as an authorized user to their account. You can benefit from someone’s positive payment history.
Check Your Personal Credit Reports
Financial experts advise consumers to check their credit reports annually to ensure no inaccurate information can damage their credit. According to the Federal Trade Commission, one in five consumers has an error on one of their three credit reports. Your credit may be low because there is an incorrect balance or delinquent account, and not because you actually did anything wrong. Equifax, Experian, and TransUnion provide one free report each year so that you can evaluate one every four months.
The Bottom Line: 5Cs of Credit
The 5 Cs of credit include character, capacity, collateral, capital, and conditions. Knowing what factors lenders analyze to determine qualification can help you prepare for loan and credit card applications!
References:
Understand The 5 C’s Of Credit Before Applying For A Loan │Forbes
Common errors people find on their credit report │Consumer Financial Protection Bureau