The 5’c of credit explained

The 5’c of credit explained

Overview

Credit analysis is governed by the 5 C’s of credit, character, capacity, condition, capital and collateral.  

The five components that make up a credit analysis help the lender understand the owner and the business and determine credit worthiness. This is because Credit analysis by a lender is used to determine the risk associated with making a loan to a potential borrower, attempting to estimate the chance of default and, consequently, the risk of a financial loss for the lender.  

For the borrower it’s also good to know each of the 5 Cs, to better understand what’s needed and how to prepare for the loan application process.  

Character  

Honesty and integrity come into play and since history is the best predictor of the future, a lender will examine the personal credit of all borrowers and guarantors involved in the loan.  

Borrowers should check credit reports before calling their lender; if there are any delinquencies, be prepared to explain. The lender may be able to make exceptions for low credit scores. 

Capacity 

It has to do with a borrower’s gross monthly income and how much debt they have. Lenders will therefore calculate a borrower’s income to debt (DTI) ratio by adding together a borrower’s total monthly debt payments and dividing that by the borrower’s gross monthly income.  

For the borrower this means that the lower their DTI, the better the chance of qualifying for a new loan. 

Capital 

Lenders consider any capital the borrower puts toward a potential investment. A large contribution by the borrower decreases the chance of default. Borrowers who can place a down payment on a home, for example, typically find it easier to receive a mortgage.  

Down payments indicate the borrower’s level of seriousness, which can make lenders more comfortable in extending credit. 

Collateral   

It gives the lender the assurance that if the borrower defaults on the loan, the lender can repossess the collateral. Car loans, for instance, are secured by cars, and mortgages are secured by homes. Collateral-backed loans, sometimes referred to as secured loans, are generally considered to be less risky for lenders to issue.  

Loans that are secured by some form of collateral are commonly offered to borrowers with lower interest rates and better terms compared to other unsecured forms of financing. 

Conditions   

Influence the lender’s desire to finance the borrower. Lenders may consider a loans interest rate and amount of principal. Or conditions that are outside of the borrower’s control, such as the state of the economy, industry trends or pending legislative changes. Conditions can also refer to how a borrower intends to use the money.  

If you’re a borrower who applies for a car loan or a home improvement loan, a lender may be more likely to approve those loans. This is because of their specific purpose, rather than a signature loan, which could be used for anything.  

Categories: Financial tips