Five fundamental principles of lending and borrowing underpin financial institutions. They’re the basis on which lenders decide whether or not an individual’s creditworthiness and potential as a borrower make them a good candidate for loan approval.
But what are the 5 Cs of credit — and why are they important? Let’s break down these key principles and how they affect you.
What are the 5 Cs of credit?
Whenever a bank, a loan service company or other organisation is deciding to give someone a loan, they need tools to assess the potential risk an individual poses — that is, how likely they are to pay the loan back in full. The tools used to make this decision are called the 5 Cs — character, capacity, capital, collateral and conditions. Let’s break down the definitions of the 5 Cs of credit a little more:
1. Character This C covers some of your personal information, but it’s less of a personality assessment and more of a credit history. Your credit history is a compilation of many financial records; it gives lenders an impression of your track record at repaying debts. Generally, a credit history report compiles data from the last 7 to 10 years, including bankruptcies, and indicates a pattern of behaviour when paying off loans.
This information is, in turn, used to generate your credit score by credit bureaus like TransUnion, Experian and Equifax. You’re entitled to free access to your credit score and history every 3 months, and you can contact these credit bureaus to provide it to you. (Psst… Sometimes credit scores themselves are counted as the 6th C of credit, but we’ve included them here.)
2. Capacity Simply put, this is your ability to repay the loan you’ve applied for. Decisions of this nature are made based on your debt-to-income (DTI) ratio. A DTI ratio is calculated by dividing a borrower's total monthly debt payments by their gross monthly income. The lower an applicant's DTI, the better the chance of qualifying for a new loan.
There are no hard and fast rules about what DTI will be acceptable to a lender, and lenders have different guidelines around this. In general, debt consolidation firms may be more lenient than big banks and other major financial institutions.
3. Capital Capital refers to any initial down payment a potential borrower is able to offer towards the payment of the loan. The most common example you may be familiar with is the down payment for a home loan. This decreases the perceived risk you will default on your loan and can make a loan more accessible, as it indicates your seriousness towards paying the loan off.
4. Collateral A valuable tool in helping a borrower secure a loan, collateral can be used to secure the value of the loan but isn’t capital (that is, it isn’t cash). You might have heard of collateral-backed loans — these are loans in which the object being paid for by the loan is itself collateral. Think of a car as collateral for a motoring loan or your house acting as collateral for your home loan and mortgage.
Lenders are generally more likely to approve collateral-backed loans such as these because they have a specific purpose; owning a home or a vehicle, for example. Signature loans, which can be for anything, are a more vague and risky proposition for lenders who want to see a safe return on their investment.
5. Conditions The fifth and final C of credit is conditions. The conditions of a loan can refer to the interest rate it attracts, the initial amount of money loaned (also known as the ‘principal’), and the purpose of the loan. Conditions don’t just take the individual applying for the loan into account. They can also include border market factors outside of your control, like the economic climate, general trends in a particular industry, and even government regulation and legislation changes.
Think of conditions as all the context, both specific and broad, surrounding your potential loan.
Why are the 5 cs of credit important?
As we’ve discussed, the 5 Cs of credit are the tools lenders like banks, mortgage brokers and debt loan consolidation services have to assess suitability for a loan. They are important for lenders because these financial organisations need to be assured of a debtor’s commitment to repaying the loan. Without this, they won’t be able to afford to keep lending for very long.
From the perspective of someone applying for a loan, it’s crucial you know what the 5 Cs of credit are. Then you can understand what lenders are looking for and make improvements to your own credit profile in order to get the loan you want.
The 5 Cs of credit might sound like they are all barriers to you receiving the money you want for a specific purpose, but they actually protect borrowers as well as lenders. They act as checks and balances for both parties. They ensure that a financial institution doesn’t take on too much risk, but they also safeguard individuals from taking on loans they have no hope of repaying.
Learn more about financial products and safe lending with Salt & Lime
At Salt & Lime, we’re passionate about empowering our customers to better understand the economy, how different financial products work, and what their individual behaviour can do to improve their financial position. To discover more educational pieces about debt, loan repayments and managing your credit score, check out our blog. Or, contact us today to receive individualised advice about how you can gain more financial freedom and meet your goals for the future.