What Are The Five Cs of Credit? (2024)

We all know the ABCs, but the Five Cs are just as important if you want to buy a house, get a job or even charge a meal. The metrics lenders use to evaluate the creditworthiness of a potential borrower are often referred to as the Five Cs of Credit . Before extending credit, a lender wants to know how likely it is a borrower will repay their debts. To do this, lenders look at available information about an applicant’s financial standing and decide how well this might fit with the circ*mstances of the loan being sought.

Why is it important for a borrower to understand the Five Cs? Before considering a loan, an applicant should know how they will be perceived “on paper” by the lender, and accordingly, what size and type of loan is within reach.

Character

No, it’s not the borrower’s personality (or even overall integrity) that lenders care about. Lenders’ judgement of character can be more or less boiled down to two words: credit history. A credit history tracks how reliably the borrower has repaid their debts in the past and is recorded in credit reports by the three major credit bureaus (Experian, Trans-Union, and Equifax). It’s often summarized by a three-digit number called a credit score.

A solid credit history and a high credit score provide advantages because they’re the clearest indicators of low risk to lenders. Risk remains the central factor in the decision to approve or deny a loan. Many lenders use a minimum credit score requirement as one of the first methods to set eligibility for a particular loan or line of credit.

Second, lenders often set rates and other terms for a loan based on the borrower’s credit score—again, because of what it tells the lender about the level of risk they’ll assume. Borrowers with good or excellent credit scores often receive more favorable conditions, meaning borrowing would be less expensive than for someone who appears riskier to lend to. Like so many other industries, it pays to be a good customer.

Capacity

While character represents a borrower’s track record with past debts, capacity is a projection about the ability to afford future debts. Lenders are interested to know if a borrower will actually have enough money at the end of the month to make payments. Lenders assess capacity by comparing a borrower’s income to any recurring debts, such as existing loans, as well as other major expenses. They also assess factors like job stability and employment history.

Capacity is most often represented by a debt-to-income ratio (DTI), expressed as a percentage, which divides monthly debt obligations by monthly gross income. To lenders, the lower a borrower’s DTI ratio, the better, because it indicates greater ease of making payments. Lenders often look for DTI ratios to be about 35% or lower before approving a loan, although other factors may change this and situations often vary. For certain types of loans, it’s actually illegal for lenders to finance a borrower with a DTI ratio above a maximum threshold.

Capital

Lenders look at a borrower’s capital in two ways: How much the borrower is worth overall and how much money the borrower has already committed to whatever it is they’re doing that requires a loan. Similar to capacity, a large amount of capital relative to the size of the loan being sought reassures the lender that money to pay off debt won’t be too hard to find. Proof of significant financial commitment by the borrower—like a large down payment on a financed home—communicates they have “skin in the game.”

Collateral

Collateral is pledged by the borrower to secure a loan, meaning the borrower has something of value to seize if the borrower defaults on repayment. Securing a loan with collateral is one of the most effective ways for lenders to reduce risk and as such, loans that incorporate collateral are oftentimes more easily approved and provide more favorable terms to the borrower.

The most common example of collateral is in a mortgage, in which the borrower pledges a home or land as collateral for the loan they use to fund a purchase. Similarly, an auto loan is usually secured by the vehicle being purchased. Cash-secured loans—which use a borrower’s savings account as collateral—are some of the easiest loans to get approved because the risk to the lender becomes virtually zero. Secured credit cards are credit card accounts secured by a cash deposit. Loans without any collateral are called unsecured loans and are more difficult to obtain without a solid credit history.

Conditions

Many other factors impact a lender’s risk-benefit assessment when considering an application. Many of these “conditions” are specific to the borrower and the transaction. These might include any information shared about what the loan is for. A loan without a designated purpose is more difficult to get approved (and may have a higher interest rate) whereas a loan for a familiar purpose such as home renovation or paying for a wedding is often seen among lenders as more desirable to finance. Other conditions lenders consider may be unrelated to the borrower, like federal interest rates, projections about the state of the economy or industry-specific legislation and trends.

Bottom Line

The Five Cs of Credit illuminate a guiding tenet of borrowing: The lower the risk to the lender, the higher the chances of approval and the more favorable the terms. Applicants for a loan should consider the Five Cs not only to determine status as a prospective borrower, but also to inform a decision about what loan to apply for. The Five Cs can help a borrower consider how much risk they’re willing to take on in pursuit of the capital they’d like.

It takes time and diligence to become creditworthy. Borrowers can influence appearance to lenders as measured by the Five Cs by maintaining a good credit history, minimizing debt and allocating capital to best convey creditworthiness.