In anything involving finance, you are likely to hear the word “credit” mentioned a lot. Credit is defined as, “the ability to borrow money or access goods or services with the understanding that you'll pay later”—so any time you use your credit card, take out a loan, or apply for a mortgage, you are utilizing the credit system.
Credit can seem like a confusing system, but breaking it down into smaller pieces can make it much easier to understand...hence, the 5 C’s of Credit. Today we will be looking at character, capacity, capital, collateral, and conditions to examine how each one can impact the type of loan you can receive—and stay tuned for our next blog so you can learn more about how to build credit, too!
A Guide to the 5 C’s of Credit
This refers to your credit history—also known as your “character” as a consumer. Your history, such as your reputation for paying back debts, is listed on your credit report. The three major bureaus which report your history are TransUnion, Experian, and Equifax. Lenders can see your payment history, but they can also see the not-so-pleasant stuff...like charge-offs and bankruptcies. The more demerits they can find, the lower your probability of getting a great rate and payment. To quantify the risk a lender would undertake to provide you with a loan, they use FICO (Fair Isaac Corp.), which is a credit evaluation firm. This is an educational tool that’s intended to provide a quick snapshot of your credit portfolio by compiling an average amount of data from the three reporting bureaus—and that is the best number to use when determining your creditworthiness.
Capacity is what lenders use to measure your ability to repay a loan. They will compare your income against current recurring debts to assess your debt-to-income (DTI) ratio. In most cases, your DTI should be below 35% to be considered lend-worthy. You must ensure you can comfortably pay all debts, so your capacity is a big part of your consideration for future loans.
Borrowers will find it easier to receive a loan when they come to the table with some skin in the game by providing capital. Whether you’re planning to place a large down payment or 2 to 5% of the value of the loan, the lender wants to know you also have some investment in this arrangement. Providing your own capital shows you have a lower chance of defaulting on a loan, which may also positively affect the terms of your loan (i.e. the term, rate, and amount you are offered). In the case of a mortgage, a capital investment of 20% will avoid the requirement of Private Mortgage Insurance (PMI).
Offering collateral on a loan (known as a secured loan) can provide you with more favorable rates than an unsecured loan. In most cases, the collateral is the object being borrowed against, and if the borrower defaults, the lender can get something back by repossessing the collateral. Secured loans are generally less risky for the lender and are seen as more favorable for borrowers as well. If you have collateral to offer for a loan, you may want to consider using it to provide yourself with better terms, rates, and in some cases, payments.
The conditions of a loan, such as its interest rate and amount of principal, influence the lender’s desire to finance you as a borrower. This refers to how a borrower intends to use the money, which should be specific. When you apply for a loan, have a great reason on hand so you can provide a specific purpose in which the lender would be willing to take a risk. Some lenders may also consider conditions that are outside of your control, such as the state of the economy, industry trends, and legislative changes.
If you need help navigating the world of credit, we’re here to help! Let us look at your financial portfolio today—contact us here for more information.