The 5 Cs of Credit

Key takeaways:

• The “5 Cs of Credit” are a method used by lenders to evaluate loan applications, consisting of: Character, Capacity, Capital, Collateral, and Conditions.
• Understanding the 5 Cs of credit can help you know what lenders look for and how to maximize their creditworthiness in the loan approval process.

When you apply for credit, a lender wants to know that you have a high probability of paying them back. And while every lender has a different methodology when it comes to evaluating applications, most use information from 5 categories. This is known as the “5 Cs of Credit,” and knowing what lenders are looking for in each category can help you know what to expect throughout the loan approval process—as well as how to maximize your own creditworthiness in the eyes of lenders.

1.       Character
2.       Capacity
3.       Capital
4.       Collateral
5.       Conditions

To be sure, you might see these in a different order, and some lenders use slightly different terminology—such as “cash flow” instead of “capacity,” but this is the general method used by lenders when deciding whether to lend you money or not. And here’s a rundown of what each of the five Cs are used in the lending process.

1. Character

You might also hear this referred to as “creditworthiness.” Character involves a lender’s assessment of your likelihood of paying back a loan on time and as agreed.

The most obvious component of character is your credit report and credit score. While credit scores are not flawless, they are designed to give lenders an overall picture of how likely you are to default on a loan. And within the credit report itself, a lender can see your payment history on each of their credit accounts, as well as any adverse information such as credit accounts that ended up getting sent to collections.

However, there’s a lot more to assessing your character than just their credit history. In fact, Upstart considers more than 1,000 data points when reviewing customers’ personal loan applications in order to get an accurate picture of their character, especially when it comes to what the traditional credit scoring models overlook.

2. Capacity

It doesn’t matter if you have a perfect 850 credit score if you can’t afford to pay back the money you borrow. So, the second “c” of credit is capacity— the borrower’s ability to repay.

There are two main components to evaluating ability to repay a loan, income and debts. And lenders often combine these into one metric known as the debt-to-income ratio, or DTI ratio. In simple terms, your DTI ratio is all of your monthly debt payments divided by your total pre-tax income. For example, if your mortgage, auto loan, credit cards, and other debt payments total $3,000 per month and your pre-tax income is $6,000 per month, your DTI ratio is 50%.

Lenders have different requirements when it comes to DTI ratios. A popular guideline financial planners use is to recommend a DTI ratio of 36% or less, but many lenders (especially mortgage lenders) will accept borrowers whose debts are significantly higher. But the point is while a lender will use your character to determine your likelihood to repay, they’ll use your capacity to determine your ability to repay.

3. Capital

This is more commonly used in mortgage and auto lending where significant down payments are common, but capital often refers to the amount of your savings and other assets that you are planning to put towards your loans.

Capital also refers to all of your assets, even those you aren’t planning to use. This includes things like savings accounts, investments, real estate assets, and other assets that could potentially be sold if needed. The idea is that if you have a lot of assets, you’d be able to keep making your loan payments even if your income went away.

4. Collateral

There are two main categories of loans—secured and unsecured. An unsecured loan is one that isn’t backed by any specific assets, such as a credit card. If you use your credit card to buy a TV and don’t pay the bill, the credit card issuer can’t simply show up and take the TV.

Secured loans, on the other hand, are those that have pledged collateral. A mortgage loan is a form of secured loan, with the collateral being the home you buy with the loan proceeds. If you stop paying your mortgage, the lender has the ability to take your home and sell it, in order to recoup its money.

Collateral can take several forms. For mortgages and auto loans, it’s your home and car, respectively. But for a personal loan or other type of loan that requires collateral, this can be money in savings accounts or CDs, investments, jewelry, collectibles, or pretty much any other asset with a quantifiable market value.

5. Conditions

You may recall at the onset of the COVID-19 pandemic that many lenders stopped opening home equity lines of credit, or HELOCs. In the wake of the financial crisis in 2008-2009, many credit card issuers lowered customers’ credit lines even though the accounts were in good standing.

These are examples of conditions. In a strong economy, lenders have more of an appetite for risk, which can result in looser credit standards. Conversely, if a recession is expected, lenders might be more cautious. Lenders might also look at how your housing market is performing, as many are reluctant to lend in declining markets.

Conditions also include how you plan to use the money. For example, many personal loans have certain restrictions, such as prohibiting you from buying any type of real estate or paying for college with personal loan proceeds.

Making the 5 Cs of credit work for you

By understanding the 5 Cs of credit, you’ll know what lenders will be looking for when you apply for credit. And while some of it is obviously out of your control (such as economic conditions), there’s a lot that you can do to help the process go smoothly and to put yourself in the best possible position for approval. For example, if you calculate your DTI ratio and find it to be a bit on the high end, you can prioritize paying down some of your debts to reduce your monthly payment obligations before you apply.