What are the 5 Cs of Credit?
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” is a common phrase used to describe the five major factors used to determine a potential borrower’s creditworthiness.
- The 5 Cs of Credit refer to Character, Capacity, Collateral, Capital, and Conditions.
- 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.
5 Cs of Credit – 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.
Owing to the degree of specialization required in compiling a detailed list of an individual’s credit history, financial intermediaries such as credit rating agencies or banks provide rating services. There may be a certain degree of variance in reports compiled by different organizations. They include the names of past lenders, type of credit extended, payment timeline, outstanding liabilities, and so on.
In some cases, credit scores may be assigned to express one’s creditworthiness numerically. A common standard is a FICO Score – which consolidates data from credit reporting bureaus, i.e., Experian, Equifax, and TransUnion – and calculates an individual’s credit score. A high score signifies less risk for the lender.
5 Cs of Credit – 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. Other responsibilities, such as college-bound children or terminally ill family members, are also factored in to evaluate one’s future payment obligations.
An entity’s Debt-to-Income (DTI) Ratio, the ratio of its current debt to current income (before taxation), may be evaluated. Collateral is not considered a fair metric for quantifying one’s capacity because it is only liquidated when the borrower fails to repay the principal amount of a loan, i.e., in the worst-case scenario of a credit transaction. Moreover, no collateral is declared in cases of unsecured loans such as credit cards.
5 Cs of Credit – Collateral
When being assessed for a secured product such as a car loan or a home loan, borrowers are required to pledge certain assets under their name as collateral. They may include fixed assets such as the title of a parcel of land or financial assets and securities such as bonds.
The value of the collateral is evaluated by deducting the value of current loans secured through the same asset. The remaining equity indicates the true value of collateral for the borrower. The evaluation of the liquidity of collateral is also dependent on the type of asset, its location, and potential marketability.
5 Cs of Credit – Capital
Capital represents the overall pool of assets under the name of the borrower. It represents one’s investments, savings, and assets such as land, jewelry, etc. Loans are primarily repaid using overall household income; capital is additional security in case of unforeseen circumstances or setbacks such as unemployment.
5 Cs of Credit – Conditions
Conditions refer to the specifics of any credit transaction, such as the principal amount or interest rate. Lenders assess risk based on how the borrower plans to use the money, should they receive it.
Other external features, such as state of the economy, prevailing federal interest rates, industry-specific legislation, and political change are also considered. The features are not individualistic as they cannot be influenced by the borrower. Nevertheless, they indicate the level of risk associated with a certain investment. For example, during a recession, even borrowers with a 700+ FICO score may not be able to access credit.