The 5 C’s of Credit
Guess which of the following is accurate. (hint: it isn’t the first one)
Lenders can use games like rock paper scissors and eenie, meenie, miney, mo to decide whether or not a loan applicant should be approved.
Lenders can use systems like the five c’s of credit to decide whether or not a loan applicant should be approved.
The 5 C’s are character, capacity, collateral, capital, and conditions. These five provide information that helps lenders to assess the likelihood of the borrower paying everything back on time.
Capacity measures a borrower’s DTI ratio. This is calculated by dividing a borrower's total monthly debt payments by their total monthly income. A low ratio shows that the borrower doesn’t already have too many other payments to make and can afford to make the loan payments as well.
Collateral is the object that the loan is being taken out for. If the borrower defaults on the loan, the lender can take the object as collateral. Lenders generally prefer collateral-backed loans because they are less risky.
Character is the credit history and reputation of the borrower. Information from credit reports/their credit score helps the lender understand the borrower’s historical performance in paying back loans.
Capital is the amount of money that the borrower initially puts towards the investment. For example, a down payment on a house followed by monthly mortgage loan payments. Putting significant capital down decreases the chances of defaulting on the loan. Therefore, the lender is more likely to approve a loan when a large contribution is made.
Conditions include the income of the borrower, as well as the state of the economy and the intended purpose of the loan. The details of the loan are important too, such as the interest rate and principal.