The 5 Cs of Credit

When someone applies for a mortgage loan, an auto loan, or a credit card, the lender wants to know that they’ll get their money back. Is the borrower likely to repay the debt in full and on time? Or is there a good chance they’ll default on the loan?

To make an educated guess, lenders turn to the 5 Cs of credit.

The 5 Cs of credit

The 5 Cs of credit are specific traits that lenders use to assess a credit or loan applicant. They give lenders an idea of how well a borrower has managed their finances and whether they can comfortably take on more debt.

How do lenders use the 5 Cs?

Lenders use the 5 Cs to decide whether to offer a loan or extend credit to a borrower. If they decide to do business with the borrower, the 5Cs also help them determine the size of the loan and the terms.

Borrowers with favorable 5 Cs, for example, might get a better interest rate on a mortgage or personal loan, or get approved for a credit card with generous rewards. Creditworthy borrowers may even get a price break on auto insurance.

What are the 5 Cs of credit?

The 5Cs of Credit are credit history, capacity, collateral, capital, and conditions.

Credit History

What it is
Your credit history or creditworthiness (sometimes referred to as character in the 5 Cs) provides insights on how you manage money.

Lenders get this information from your credit report, which is compiled by the major credit bureaus — Equifax, Experian, and TransUnion. Your credit report sheds light on how much you’ve borrowed in the past, for example, and whether you’ve made prompt payments.

There are two main types of credit scores. While there are differences in how they’re calculated, they draw from similar data.

Your FICO score is based on data collected about you from a specific bureau, such as Experian. A “good” FICO score is generally 670 or higher, although what qualifies as a good score varies from one bureau to the next.

Your VantageScore is based on data collected from all three credit bureaus, and lenders usually consider a score of 700 or higher good.

How you can improve it
Is your credit score lower than you’d like? Not to worry. There are steps you can take to boost your number.

• Double-check your credit report. Check your credit score. If your report says you paid your monthly bill late, but you didn’t, file a dispute with the credit bureau. Simply removing mistakes from your credit report can help raise your score. Moving forward, check your credit report regularly.
• Make payments on time. Paying your bills on time signals that you’re a responsible borrower. Late or missed payments get reported to the credit bureaus, so stay on top of your bills
• Pay down debt. Lenders consider how much of your available credit you’re currently using (your utilization rate). Let’s say you have a credit card credit limit of $10,000, and your credit card balance is $9,000. That’s a high utilization rate, which can lower your credit score. Try to pay down credit card debt and other debt, aiming to get your utilization rate down to 30%.
• Avoid repeatedly applying for credit. When you apply for a credit card or a loan, the lender will run a “hard inquiry” on your credit. This won’t ding your credit score too much — usually less than 5 points. But filling out several applications can do more damage to your credit score. So apply thoughtfully.
• Ask for a credit limit increase on an existing account. If you have a credit card that you’ve been using responsibly, ask the issuer to bump up your credit limit. This will give you more unused credit, thereby reducing your utilization.
• Maintain old credit card accounts. Lenders like to see a long history of credit usage. So if you’re tempted to cancel an old credit card that you no longer use, take a pause. Keeping that card active helps you build a long credit history. And if you have a low balance, or no balance, it also lowers your overall utilization rate.

Capacity

What it is
Capacity refers to your ability to repay a loan. To assess your capacity, lenders look at your debt-to-income ratio (DTI). They essentially add up your monthly debt payments, then divide that number by your gross monthly income to arrive at a percentage. The lower your DTI, the better. Lenders generally prefer a DTI of 36% or lower, although there may be some wiggle room.

How you can improve it
Take these steps to improve your debt-to-income ratio.

• Increase your income. Are you due for a raise? Speak to your supervisor. Could you take on a side gig? Even boosting your income a bit will improve your DTI.
• Reduce your spending. Learn to form good spending habits. Spending less money helps you avoid racking up more debt while freeing up funds to help pay down the debt you already have.
• Lower your debt. If you need guidance, a Patelco Certified Financial Specialist can help.

Collateral

What it is
Collateral is something of value that you own — a car, real estate, or money in a savings account — that you can use to back up a loan.

Offering collateral reduces the lender’s risk. If you’re unable to repay a loan, the lender can seize your collateral to recoup their loss. Keep in mind that different lenders accept different types of collateral.
How you can improve it

You can use collateral by agreeing to a special type of contract with a lender. If you aren’t able to get a traditional credit card, for example, you can apply for a “secured” credit card. This type of credit card requires that you make a cash deposit as collateral. Your card’s credit limit usually equals your deposit.

Capital

What it is
Capital refers to money that you’re willing to put toward a purchase. If you’re applying for an auto loan or a mortgage, your down payment is capital. When you put a large chunk of your own money toward a major purchase, lenders assume that you’ll be less likely to default on the loan.

How you can improve it
If you plan to take out a loan for a large purchase, you’ll want to show prospective lenders that you have capital. Start by learning how to save for a goal.

Conditions

What it is
Conditions are factors that lenders consider beyond your personal finances. They might include your job stability and the current economy. If you’re applying for a business loan, they might consider the health of the industry you’re in.

How you can improve it
Conditions are often outside of your control. To address any concerns your lender might have, simply be prepared to make a solid case for why you’re in a good financial position to repay a loan.

Credit report errors — more common than you think

When Consumer Reports enlisted 3,000 people to check the accuracy of their credit report, 44% found at least one error.

How do the 5 Cs work together?

Each of the 5 Cs is important, although lenders may weigh them differently. Lenders tend to pay most attention to credit history and capacity, but there are exceptions. And in some cases, one “C” may offset the others.

If you make a large down payment on a car, for example, your lender may offer you better loan terms, even if your credit history isn’t stellar. Or, if you’re applying for a credit card but have a low credit score, providing collateral can make up for it. You can apply for a secured credit card, which requires you to make a cash deposit. This eliminates the lender’s risk, so they might be willing to overlook your poor credit history.