Understanding the 5 Cs of Credit

The five-Cs-of-credit method of evaluating a borrower incorporates

both qualitative and quantitative measures. Lenders may look at a borrower’s
credit reports, credit scores, income statements, and other documents
relevant to the borrower’s financial situation. They also consider information
about the loan itself.

Each lender has its own method for analyzing a borrower’s creditworthiness.
Most lenders use the five Cs—character, capacity, capital, collateral, and
conditions—when analyzing individual or business credit applications.

1. Character
Character, the first C, more specifically refers to credit history, which is a
borrower’s reputation or track record for repaying debts. This information
appears on the borrower’s credit reports, which are generated by the three
major credit bureaus: Equifax, Experian, and TransUnion. Credit reports
contain detailed information about how much an applicant has borrowed in
the past and whether they have repaid loans on time.

These reports also contain information on collection accounts and

bankruptcies, and they retain most information for seven to 10
years.1 Information from these reports helps lenders evaluate the
borrower’s credit risk. For example, FICO uses the information found on a
consumer’s credit report to create a credit score, a tool that lenders use for a
quick snapshot of creditworthiness before looking at credit reports.

FICO Scores range from 300 to 850 and are designed to help lenders predict
the likelihood that an applicant will repay a loan on time.2 Other firms, such
as VantageScore, a scoring system created by a collaboration of Equifax,
Experian, and TransUnion, also provide information to lenders.3

Many lenders have a minimum credit score requirement before an applicant

is approved for a new loan. Minimum credit score requirements generally
vary from lender to lender and from one loan product to the next. The general
rule is the higher a borrower’s credit score, the higher the likelihood of being
approved.
Lenders also regularly rely on credit scores to set the rates and terms of
loans. The result is often more attractive loan offers for borrowers who have
good to excellent credit. Given how crucial a good credit score and credit
reports are to secure a loan, it’s worth considering one of the best credit
monitoring services to ensure that this information stays safe.

Improving Your 5 Cs: Character

Prospective borrowers should ensure that credit history is correct and
accurate on their credit report. Adverse, incorrect discrepancies can be
detrimental to your credit history and credit score. Consider implementing
automatic payments on recurring billings to ensure future obligations are paid
on time. Paying monthly recurring debts and building a history of on-time
payments help to build your credit score.

2. Capacity
Capacity measures the borrower’s ability to repay a loan by comparing
income against recurring debts and assessing the borrower’s debt-to-income
(DTI) ratio. Lenders calculate DTI by adding a borrower’s total monthly debt
payments and dividing that by the borrower’s gross monthly income. The
lower an applicant’s DTI, the better the chance of qualifying for a new loan.

Every lender is different, but many lenders prefer an applicant’s DTI to be

around 35% or less before approving an application for new financing. It is
worth noting that sometimes lenders are prohibited from issuing loans to
consumers with higher DTIs as well.

For example, qualifying for a new mortgage typically requires a borrower

have a DTI of 43% or lower to ensure that the borrower can comfortably
afford the monthly payments for the new loan, according to the Consumer
Financial Protection Bureau (CFPB).4

Improving Your 5 Cs: Capacity

You can improve your capacity by increasing your salary or wages or
decreasing debt. A lender will likely want to see a history of stable income.
Although switching jobs may result in higher pay, the lender may want to
ensure that your job security is stable and that your pay will continue to be
consistent.

Lenders may consider incorporating freelance, gig, or other supplemental

income. However, income must often be stable and recurring for maximum
consideration and benefit. Securing more stable income streams may
improve your capacity.

Regarding debt, paying down balances will continue to improve your

capacity. Refinancing debt to lower interest rates or lower monthly payments
may temporarily alleviate pressure on your debt-to-income metrics, though
these new loans may cost more in the long run. Be mindful that lenders may
often be more interested in monthly payment obligations than in full debt
balances. So, paying off an entire loan and eliminating that monthly obligation
will improve your capacity.

Lenders may also review a lien and judgments report, such as LexisNexis
RiskView, to further assess a borrower’s risk before they issue a new loan
approval.5

3. Capital
Lenders also consider any capital that the borrower puts toward a potential
investment. A large capital contribution by the borrower decreases the
chance of default.

Borrowers who can put a down payment on a home, for example, typically
find it easier to receive a mortgage—even special mortgages designed to
make homeownership accessible to more people. For instance, loans
guaranteed by the Federal Housing Administration (FHA) and the
U.S. Department of Veterans Affairs (VA) may require a down payment of
3.5% or higher.67 Capital contributions indicate the borrower’s level of
investment, which can make lenders more comfortable about extending
credit.

Down payment size can also affect the rates and terms of a borrower’s loan.
Generally, larger down payments or larger capital contributions result in
better rates and terms. With mortgage loans, for example, a down payment of
20% or more should help a borrower avoid the requirement to purchase
additional private mortgage insurance (PMI).

Improving Your 5 Cs: Capital

Capital is often obtained over time, and it might take a bit more patience to
build up a larger down payment on a major purchase. Depending on your
purchasing time line, you may want to ensure that your down payment
savings are yielding growth, such as through investments. Some investors
with a long investment horizon may consider placing their capital in index
funds or exchange-traded funds (ETFs) for potential growth at the risk of loss
of capital.

Another consideration is the timing of the major purchase. It may be more

advantageous to move forward with a major purchase with a lower down
payment as opposed to waiting to build capital. In many situations, the value
of the asset may appreciate (such as housing prices on the rise). In these
cases, it would be less beneficial to spend time building capital.

4. Collateral
Collateral can help a borrower secure loans. It gives the lender the assurance
that if the borrower defaults on the loan, the lender can get something back
by repossessing the collateral. The collateral is often the object for which one
is borrowing the money: Auto loans, for instance, are secured by cars, and
mortgages are secured by homes.

For this reason, collateral-backed loans are sometimes referred to

as secured loans or secured debt. They are generally considered to be less
risky for lenders to issue. As a result, loans that are secured by some form of
collateral are commonly offered with lower interest rates and better
terms compared to other unsecured forms of financing.

Improving Your 5 Cs: Collateral

You may improve your collateral by simply entering into a specific type of
loan agreement. A lender will often place a lien on specific types of assets to
ensure that they have the right to recover losses in the event of your default.
This collateral agreement may be a requirement for your loan.

Some other types of loans may require external collateral. For example,
private, personal loans may require placing your car as collateral. For these
types of loans, ensure you have assets that you can post, and remember that
the bank is only entitled to these assets if you default.

5. Conditions
In addition to examining income, lenders look at the general conditions
relating to the loan. This may include the length of time that an applicant has
been employed at their current job, how their industry is performing, and
future job stability.

The conditions of the loan, such as the interest rate and the amount
of principal, influence the lender’s desire to finance the borrower. Conditions
can refer to how a borrower intends to use the money. Business loans that
may provide future cash flow may have better conditions than a house
renovation during a slumping housing environment in which the borrower has
no intention of selling.

Additionally, lenders may consider conditions outside of the borrower’s

control, such as the state of the economy, industry trends, or pending
legislative changes. For companies trying to secure a loan, these
uncontrollable conditions may be the prospects of key suppliers or customer
financial security in the coming years.

Some consider the criteria that lenders use as the four Cs. Because
conditions may be the same from one debtor to the next, it is sometimes
excluded to emphasize the criteria most in control of a debtor.
Improving Your 5 Cs: Conditions
Conditions are the least likely of the five Cs to be controllable. Many
conditions such as macroeconomic, global, political, or broad financial
circumstances may not pertain specifically to a borrower. Instead, they may
be conditions that all borrowers may face.

A borrower may be able to control some conditions. Ensure that you have a
strong, solid reason for incurring debt, and be able to show how your current
financial position supports it. Businesses, for example, may need to
demonstrate strong prospects and healthy financial projections.

What are the 5 Cs of credit?

The five Cs of credit are character, capacity, collateral, capital, and
conditions.

Why are the 5 Cs important?

Lenders use the five Cs to decide whether a loan applicant is eligible for
credit and to determine related interest rates and credit limits. They help
determine the riskiness of a borrower or the likelihood that the loan’s principal
and interest will be repaid in a full and timely manner.
Which of the 5 Cs is the most important?
Each of the five Cs has its own value, and each should be considered
important. Some lenders may carry more weight for categories than others
based on prevailing circumstances.

Character and capacity are often most important for determining whether a
lender will extend credit. Banks utilizing debt-to-income (DTI) ratios,
household income limits, credit score minimums, or other metrics will usually
look at these two categories. Though the size of a down payment or collateral
will help improve loan terms, these two are often not the primary factors in
how a lender determines whether to expend credit.
5 Cs of Credit: What Banks Look for When Lending
While banks don't have universal rules about what makes a person or business creditworthy,
they're guided by some general principles. The five Cs of credit—character, capacity, capital,
collateral and conditions—offer a solid credit analysis framework that banks can use to make
lending decisions. Making choices that reflect the five Cs and building the habits you need to get
there can take some of the stress out of applying for a new credit card or loan.

The five Cs provide a helpful rubric to measure your creditworthiness based on several factors.
Let's dive in to the definition and purpose of each factor to learn why the five Cs of credit are
important to determine loan eligibility.
 How do banks decide if you're a good credit risk for a loan?
They use the 5 Cs.
 Character: Are you a responsible borrower?
 Capacity: Can you reasonably take on more debt?
 Capital: Are you making a down payment?
 Collateral: Do you have any assets to put up against a loan?
 Conditions: How's the economy?
1 Character
Character helps lenders discern your ability to repay a loan. Particularly important to character is
your credit history. Your credit report will show all debts from the past 7 to 10 years. It provides
insight into your ability to make on-time payments, as well as your length and mix of credit.
Your credit report will also assign you a FICO® score ranging from 300 to 850. Many lenders
have a minimum FICO score you need to meet before you're eligible for a loan. Typically, the
higher your score, the more likely you are to qualify for the types of credit you're after.
If you're a small business owner, lenders are likely to ask your permission to review your
personal credit reports and will contact your bank to verify your handling of checking accounts
and existing loans. Your personal credit history directly reflects your character and affects your
ability to borrow for your business.
How to improve your credit character
Begin by ensuring that your credit report is accurate. You can request a free copy of your credit
report from AnnualCreditReport.com, Opens in a new tab once a year. If you find any
discrepancies, report them to the three major credit bureaus: Equifax, Experian and TransUnion.
Payment history is one of the largest components of your FICO score. One way is to pay your
bills on time by setting up automatic online payments for your debts. You can also pay down
existing debt or use a co-signer with good credit when applying for a loan.
2 Capacity
Capacity measures your ability to repay new debt based on your current obligations. Here, your
cash flow is paramount, along with your debt-to-income ratio.
Lenders want to know how much you owe versus how much you own. The lower your debt-to-
income ratio, the more favorably a bank will look at your request for credit. Other considerations
include length of time at your current job and income stability.
How to improve your credit capacity
First, calculate your personal debt-to-income ratio by dividing your total monthly debt by your
gross monthly income. Assess if the number is too high to apply for additional debt. Typically,
banks look for a debt-to-income ratio of less than 36% as an indicator that a borrower is
responsible with credit.
If you have low capacity due to a high debt-to-income ratio, try to pay down your debt. Debt
consolidation or refinancing can help you improve your cash flow. Also, apply for a loan when
you know you can prove job or income stability. The longer you're at a job—or have been in
business—the more favorable your chances for a loan.
You can use a personal debt consolidation calculator or business debt consolidation calculator to
determine whether you should consolidate your debt.
3 Capital
Capital shows lenders you're serious and committed to the credit you're seeking. For a business
loan, this means you've invested some of your own money into the business. For individual
loans, this means having a down payment when applying for a loan or mortgage.
Down payments reduce the loan amount you'll need to finance your purchase. For example, if
you purchase a $250,000 house with a 20% down payment, your loan amount is reduced by
$50,000. Your $200,000 mortgage represents 80% of your home's value—in other words, your
loan-to-value ratio is 80%. In mortgage lending, borrowers with a loan-to-value ratio of 80% or
lower usually qualify for the best interest rates.
Do you have any cash on hand to provide as capital? Often, the more equity you have, the more
favorable your loan conditions will be.
How to improve your credit capital
If you don't have savings, there are loans you can still apply for without capital. Your loan terms
may not be as desirable, but if you're in good standing with the other Cs of credit, a bank may
still lend you money.
If you don't need to borrow right away, you can build capital over time. Stick to a budget, find
ways to save and create an emergency fund before borrowing. If an unexpected event occurs—
such as losing your job—you'll want a nest egg to continue making timely payments on your
loan.
4 Collateral
Collateral provides assurance to the bank in case you're unable to pay for the loan. For example,
if you secure an auto loan, the car is your collateral. If you default on your loan, the bank can
repossess the car.
During the credit analysis phase, lenders will look at what sort of property—bank accounts, real
estate, equipment or automobiles—they'll be able to use as collateral when they offer you a loan.
Without collateral to secure your loan, lenders will see you as a bigger risk.
How to improve your credit collateral
Take stock of your possessions. Do you owe debt on any of them? What's the value of your
property? These items may be seen as collateral if you're unable to repay your loan.
If you don't have collateral but still need to secure a loan, you might look for a co-signer. This is
a person who has collateral to back the loan. Remember, using a co-signer is a big responsibility.
You now have your own—and someone else's—financial security at stake.
5 Conditions
This refers to the current economic health of the market and the industry you work in. Is the
country going through an expansion or a recession? Are your prospects for advancing in your
professional life currently growing or shrinking? What are the current employment trends, and
are there layoffs expected?
How to improve your credit conditions
This component of the five Cs of credit is the least in your control, which makes it critical to plan
ahead. Banks are more willing to give you credit during expansionary periods. When market
conditions are favorable, this may be a good time to see what terms are available for the types of
credit you're currently seeking.
Having a clear plan in place for what you want to do with the money can help you or your
business secure a loan. In slower economic periods, banks prefer specific loans—such as home
improvement loans—over signature loans, which can be used for any purpose.
 Build a strong financial foundation
Keep these characteristics in mind as you try to better understand your credit situation and work
toward your financial goals. If you can show a history of responsibly using credit in a way that
reflects the five Cs of credit, you'll put yourself in a better position to obtain the financing you
need to build the life you want.

While banks don't have universal rules about what makes a person or business creditworthy,
they're guided by some general principles. The five Cs of credit—character, capacity, capital,
collateral and conditions—offer a solid credit analysis framework that banks can use to make
lending decisions. Making choices that reflect the five Cs and building the habits you need to get
there can take some of the stress out of applying for a new credit card or loan.

They use the 5 Cs.

 Character: Are you a responsible borrower?
 Capacity: Can you reasonably take on more debt?
 Capital: Are you making a down payment?
 Collateral: Do you have any assets to put up against a loan?
 Conditions: How's the economy?

1. Character
Character, the first C, more specifically refers to credit history, which is a
borrower’s reputation or track record for repaying debts. This information
appears on the borrower’s credit reports, which are generated by the three
major credit bureaus: Equifax, Experian, and TransUnion. Credit reports
contain detailed information about how much an applicant has borrowed in
the past and whether they have repaid loans on time.

These reports also contain information on collection accounts and

bankruptcies, and they retain most information for seven to 10
years.1 Information from these reports helps lenders evaluate the
borrower’s credit risk.

If you're a small business owner, lenders are likely to ask your permission to review your
personal credit reports and will contact your bank to verify your handling of checking accounts
and existing loans. Your personal credit history directly reflects your character and affects your
ability to borrow for your business.

How to improve your credit character

Prospective borrowers should ensure that credit history is correct and

accurate on their credit report. Adverse, incorrect discrepancies can be
detrimental to your credit history and credit score. Consider implementing
automatic payments on recurring billings to ensure future obligations are paid
on time. Paying monthly recurring debts and building a history of on-time
payments help to build your credit score.

2. Capacity
Capacity measures the borrower’s ability to repay a loan by comparing
income against recurring debts and assessing the borrower’s debt-to-income
(DTI) ratio. Lenders calculate DTI by adding a borrower’s total monthly debt
payments and dividing that by the borrower’s gross monthly income. The
lower an applicant’s DTI, the better the chance of qualifying for a new loan.
Every lender is different, but many lenders prefer an applicant’s DTI to be
around 35% or less before approving an application for new financing. It is
worth noting that sometimes lenders are prohibited from issuing loans to
consumers with higher DTIs as well.

How to improve your credit capacity

First, calculate your personal debt-to-income ratio by dividing your total monthly debt by your
gross monthly income. Assess if the number is too high to apply for additional debt. Typically,
banks look for a debt-to-income ratio of less than 36% as an indicator that a borrower is
responsible with credit.
If you have low capacity due to a high debt-to-income ratio, try to pay down your debt. Debt
consolidation or refinancing can help you improve your cash flow. Also, apply for a loan when
you know you can prove job or income stability. The longer you're at a job—or have been in
business—the more favorable your chances for a loan.

3. Capital
Lenders also consider any capital that the borrower puts toward a potential
investment. A large capital contribution by the borrower decreases the
chance of default.

Borrowers who can put a down payment on a home, for example, typically
find it easier to receive a mortgage—even special mortgages designed to
make homeownership accessible to more people. For instance, loans
guaranteed by the Federal Housing Administration (FHA) and the
U.S. Department of Veterans Affairs (VA) may require a down payment of
3.5% or higher.67 Capital contributions indicate the borrower’s level of
investment, which can make lenders more comfortable about extending
credit.

mproving Your 5 Cs: Capital

Capital is often obtained over time, and it might take a bit more patience to
build up a larger down payment on a major purchase. Depending on your
purchasing time line, you may want to ensure that your down payment
savings are yielding growth, such as through investments. Some investors
with a long investment horizon may consider placing their capital in index
funds or exchange-traded funds (ETFs) for potential growth at the risk of loss
of capital.
Another consideration is the timing of the major purchase. It may be more
advantageous to move forward with a major purchase with a lower down
payment as opposed to waiting to build capital. In many situations, the value
of the asset may appreciate (such as housing prices on the rise). In these
cases, it would be less beneficial to spend time building capital.

4. Collateral
Collateral can help a borrower secure loans. It gives the lender the assurance
that if the borrower defaults on the loan, the lender can get something back
by repossessing the collateral. The collateral is often the object for which one
is borrowing the money: Auto loans, for instance, are secured by cars, and
mortgages are secured by homes.

For this reason, collateral-backed loans are sometimes referred to

as secured loans or secured debt. They are generally considered to be less
risky for lenders to issue. As a result, loans that are secured by some form of
collateral are commonly offered with lower interest rates and better
terms compared to other unsecured forms of financing.

Improving Your 5 Cs: Collateral

You may improve your collateral by simply entering into a specific type of
loan agreement. A lender will often place a lien on specific types of assets to
ensure that they have the right to recover losses in the event of your default.
This collateral agreement may be a requirement for your loan.

How to improve your credit collateral

Take stock of your possessions. Do you owe debt on any of them? What's the value of your
property? These items may be seen as collateral if you're unable to repay your loan.
If you don't have collateral but still need to secure a loan, you might look for a co-signer. This is
a person who has collateral to back the loan. Remember, using a co-signer is a big responsibility.
You now have your own—and someone else's—financial security at stake.

5. Conditions
In addition to examining income, lenders look at the general conditions
relating to the loan. This may include the length of time that an applicant has
been employed at their current job, how their industry is performing, and
future job stability.
The conditions of the loan, such as the interest rate and the amount
of principal, influence the lender’s desire to finance the borrower. Conditions
can refer to how a borrower intends to use the money. Business loans that
may provide future cash flow may have better conditions than a house
renovation during a slumping housing environment in which the borrower has
no intention of selling.

Additionally, lenders may consider conditions outside of the borrower’s

control, such as the state of the economy, industry trends, or pending
legislative changes. For companies trying to secure a loan, these
uncontrollable conditions may be the prospects of key suppliers or customer
financial security in the coming years.

How to improve your credit conditions

This component of the five Cs of credit is the least in your control, which makes it critical to plan
ahead. Banks are more willing to give you credit during expansionary periods. When market
conditions are favorable, this may be a good time to see what terms are available for the types of
credit you're currently seeking.
Having a clear plan in place for what you want to do with the money can help you or your
business secure a loan. In slower economic periods, banks prefer specific loans—such as home
improvement loans—over signature loans, which can be used for any purpose.