You probably know that having a good credit score is key to getting a loan, but do you know what else lenders are looking for? Whether you’re taking out a personal loan, refinancing an auto loan or applying for a mortgage, lenders typically look at five factors when assessing your creditworthiness—also known as the 5 C’s of credit.
The 5 C’s of credit are the qualitative and quantitative considerations a lender will review before deciding whether to give you a loan and at what interest rate. This process helps to determine your credit risk, or how likely it is that you’ll be able to repay the loan.
Understanding what lenders look for is crucial to qualifying for a loan at the lowest rate possible. So what are the 5 C’s of credit, and how can you master them? Read on to find out.
The 5 C’s of credit are Character, Capacity, Collateral, Capital, and Conditions. Mastering all five of these credit factors could help you obtain a good credit score and lower your interest rates next time you need a loan.
Here’s the 5 C’s of credit with descriptions of each:
Lenders will look at your reputation or “character” as a borrower. This is also referred to as credit history, or your track record of managing your debts.
Your credit history can be found on your credit report, which outlines in detail your payment history and types of credit you have, such as personal loans, student loans, credit cards, etc. This helps lenders get a sense of how responsible you are and how likely it is that you’ll pay back your loan on time.
Your credit score may also be taken into consideration. This is a number that represents your risk as a borrower. Typically, the higher the score, the less risky you seem. Many lenders require minimum credit scores for borrowers and use your credit score and history to determine rates.
How to master “character”: Keep your credit score and history in good shape by making payments on time, every time.
Capacity is one of the most important of the 5 C’s of credit. Essentially, a lender will look at your cash flow and income, employment history and outstanding debts to determine if you can comfortably afford another loan payment.
Lenders may use debt to income ratio, or DTI, to determine your capacity. This is the ratio between your gross (before tax) monthly income and the current debts you have.
The lower your DTI, the more capacity you have to take on more debt. As for the types of income and debt a lender will consider, it varies by company.
To calculate your DTI, take your gross income and divide it by the total of all your current debt. You’ll get a decimal number which you can then convert into a percentage. For example, if your calculations give you 0.75, your DTI is 75%.
How to master “capacity”: Most lenders prefer DTI to be lower than 40%, so you may want to pay down some debt to hit that ratio before applying for a new loan.
Depending on the type of loan, you may have a choice between a secured or unsecured loan. An unsecured loan is one where you don’t need to put up any collateral, whereas a secured loan does require collateral. Collateral is an asset you agree to give up to the lender if you default on your loan. For example, in the case of a car loan, the collateral is usually the car.
A lender will assess the value of your collateral, including any debt that has already been secured by it. The leftover equity is then used to determine whether you’ll be approved or denied and/or need to make an additional deposit to secure the loan.
This is done using loan to value ratio, or LTV. The LTV is the ratio of your collateral’s current value to how much you want to borrow. For example, an 80% LTV means you’re borrowing 80% of what your collateral is worth.
Lenders want the LTV to be as low as possible to protect their investment. If you default on your loan, the lender can then repossess and sell off the collateral in order to recoup their losses.
How to master “collateral”: For home loans, the magic LTV ratio is typically 80%. For auto loans and auto refinancing, lenders will typically look for an LTV under 130% of the total value.
Capital refers to the money you put towards a loan. This typically refers to a down payment but can include other types of personal assets or investments. Generally speaking, the larger the down payment, the easier it may be to get a loan.
Lenders may require a larger down payment from borrowers who want an unsecured loan and don’t have great credit. A down payment tends to make lenders feel more comfortable in lending out more money as it indicates the borrower’s seriousness in paying back a loan.
How to master “capital”: Capital usually comes into play with a mortgage, where a 20% down payment is the industry standard.
In some cases, the lender will want to know how you plan to use the loan. In the case of auto loans, mortgages and student loans, clearly your options are limited. But if you’re taking out a personal or small business loan, the lender may ask how you will use the money, and those “conditions” can factor into their decision.
Conditions can also refer to the market environment in which the loan is being made – for example, if you’re taking out a variable rate loan at a time when interest rates are on the rise, that can add an extra layer of risk to your ability to repay the loan—and lenders will take note.
How to master “conditions”: If your stated purpose for a loan is something irresponsible or reckless, it will give lenders a reason not to approve your application. Instead, use debt for things that can improve your financial situation—for example, refinancing a high interest rate auto loan at a lower rate.
Now that you know what lenders are looking for when evaluating your loan application, you can take steps to better prepare for success. The biggest rule of thumb is to always use debt—and pay it back—responsibly, and you’ll improve your chances of getting approved at lower rates. Next time you need personal credit or business credit, remember to revisit your 5 C’s!
COVID-19 has created an unprecedented burden for small businesses around the world. As America’s largest online credit marketplace, we…READ MORE
In response to the global pandemic, many credit card providers, lenders, insurers, and loan servicers have stepped up in…READ MORE
As COVID-19 has made its way around the globe, countless self-employed, independent contractors, and small business owners are facing…READ MORE