The “5 Cs of Credit” is a common phrase used to describe the five major factors used to determine a potential borrower’s creditworthiness. Financial institutions use credit ratings to quantify and decide whether an applicant is eligible for credit and to determine the interest rates and credit limits for existing borrowers. A credit report provides a comprehensive account of the borrower’s total debt, current balances, credit limits, and history of defaults and bankruptcies, if any.
The 5 Cs of Credit refer to Character, Capacity, Collateral, Capital, and Conditions.
Character– Character is the most comprehensive aspect of the evaluation of creditworthiness. The premise is that an individual’s track record of managing credit and making payments indicates their “character” as relevant to the lender, i.e., their propensity for repaying a loan on time. Past defaults imply negligence or irresponsibility, which are undesirable character traits.
Capacity– A borrower’s capacity to repay the loan is a necessary factor for determining the risk exposure for the lender. One’s income amount, history of employment, and current job stability indicate the ability to repay outstanding debt. For example, small business owners with unsteady cash flows may be considered “low capacity” borrowers.
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. Often, the collateral is the object one is borrowing the money for: Auto loans, for instance, are secured by cars, and mortgages are secured by homes,
Capital- Lenders also consider any capital the borrower puts toward a potential investment. A large contribution by the borrower decreases the chance of default. Borrowers who can place a down payment on a home, for example, typically find it easier to receive a mortgage. Down payments indicate the borrower’s level of seriousness, which can make lenders more comfortable in extending credit.
Conditions– The conditions of the loan, such as its interest rate and amount of principal, influence the lender’s desire to finance the borrower. Conditions can refer to how a borrower intends to use the money. Consider a borrower who applies for a car loan or a home improvement loan. A lender may be more likely to approve those loans because of their specific purpose, rather than a signature loan, which could be used for anything.
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