Credit Risk: Understanding the 5 C’s of Credit

There are many different aspects of credit that most people don’t understand. In fact, studies have shown that one out of eight Americans had no idea what their credit score was. 71% don’t understand how having bad credit can impact their life.

Having good or bad credit can affect your life in a number of different ways. To assess your creditworthiness, lenders use a system called the 5 C’s of credit. But what are they?

Keep reading to learn about the 5 C’s of credit, and how lenders go about understanding credit risk.

Character

The first C of credit refers to character or credit history. This includes your history and reputation for paying back debts. Credit bureaus generate this information then post it on your credit report. 

Your credit report shows how much you’ve borrowed, and also whether or not you paid it back on time. Credit reports also contain information on bankruptcies and collection accounts. 

Capacity

Capacity, or cash flow, refers to your ability to repay a loan. Lenders look at your debt-to-income ratio, or DTI, to make their assessments. To calculate your DTI, they add your monthly debt payments and divide that number by your monthly income.

The lower your DTI, the better. Many lenders only accept applicants if their DTI is less than 35%. To take advantage of powerful different financial tools, check out CreditRiskMonitor

Conditions 

Aside from your personal credit history, other conditions impact a lender’s willingness to finance you. This can include things such as the amount of principal, the interest rate, the state of the economy, and how you plan on using the money.

For example, if you apply for a home improvement loan or car loan, the purpose of what you’ll use it for is clear. If other factors check out, you should have no issue getting a lender to approve your loan application. On the other hand, lenders may be less willing to accept a loan that you can use for anything.

Capital

Lenders also take into consideration how much capital you put towards an investment. If it’s a large contribution, there’s a reduced chance of you needing to default. 

For the most part, larger down payments yield better terms and rates. For example, making a mortgage down payment of more than 20% can help you avoid some hassles later on. 

Collateral

Collateral can help you secure a loan. It shows lenders that if you do need to default, they’ll be able to get something back. In most cases, the collateral is what you’re borrowing money for. For example, the collateral with auto payments is your car. 

Lenders view loans that come with collateral as less risky options. Often times, these have better terms and lower interest rates than less secure financing forms. 

Understand the 5 C’s of Credit 

Understanding your credit and the different parts of it can be difficult. Yet after reading this guide, you now understand more about the 5 C’s of credit, as well as how important they are. 

What are the 5 C’s of credit? Do you have anything else to add about them? Make sure to let us know.

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