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Understanding 5 Cs of Credit

Submitted by admin on April 18th, 2024

Whether it is an individual or enterprise applying for a loan, a lender considers multiple factors before deciding if the request should be approved. Usually, lenders stick to the 5Cs of Credit: Character, Capacity, Capital, Collateral, and Conditions. Lenders review each of these big Cs to read the risk related to approving loans to borrowers. For your clear understanding, we have broken each C into details.

Character: This C is about a borrower’s reputation and track record in managing financial matters. Lenders strongly believe that a potential borrower’s behavioral history is a significant indicator of the person’s future conduct.

Each lender has a unique set of parameters for the assessment of a borrower’s character, adopting a mix of quantitative and qualitative methods for the purpose. However, an important part of this process usually involves checking the applicant’s credit score or history. Credit reporting agencies usually follow a standardized scale while delivering information.

Capacity: Capacity is a borrower’s ability to pay off loans. Lenders evaluate a borrower’s capacity by examining the person’s debt-to-income ratio. This is calculated by summing up the borrower’s debt payments and then dividing the total by his/her pre-tax monthly earnings and finally, multiplying the result by 100.

For lenders, the rule of thumb is: that the lower the DTI ratio, the lower the risk for loan approval. In other words, a low DTI ratio indicates that the borrower can manage an additional burden for monthly debt payments.

As per the Consumer Financial Protection Bureau, it is advised to maintain a DTI ratio of 15%-20% or less for renters or 36% or less for homeowners.

Capital: Capital means your assets, savings, and investments that you want to allocate for your loan. For example, the down payment for buying a home is a form of capital. With a larger down payment, a borrower can secure better interest rates and loan tenures. This is because a high down payment is an indication of a borrower’s ability and commitment to pay off the loan.

Though a borrower’s monthly earnings are the main source of loan repayment, having capital is a guarantee for an additional layer of security for lenders, in the aftermath of unexpected events such as job loss that can negatively affect the person’s obligations towards timely repayment.

Collateral: Offering collateral plays a role in favoring a borrower’s chance of getting a loan. This is because if the person cannot repay the loan, the lender can claim the possession of the collateral as repayment.

Collateral can be presented in the form of a house, a car, or other negotiated assets. Offering collateral might also benefit the borrower with a favorable interest rate as it reduces the risk for lenders.

Condition: This ‘C’ includes additional details that are important in determining a borrower’s eligibility for obtaining a loan and the tenure the lender will offer. Lenders consider different conditions before sanctioning a loan.  These are:

External Factors: Some conditions, such as industry trends, the economic condition of the state, etc are beyond a borrower’s control. However, lenders always assess these factors to understand the level of risk before approving credit.

Intended Use of Funds: Lenders are more likely to approve loans for a particular purpose, rather than sanctioning general personal credit.