The 5 Cs of Credit & Getting Approved for a Loan

We’ve all been there; applying for any kind of loan can be nerve-wracking. You may need some extra funds for a variety of reasons like a new car, tuition, a mortgage, or an emergency. Most people, or borrowers, are familiar with the process. You gather the necessary documents, fill out the application online or in person, wait to learn if you’re approved, gain access to your funds, and then begin the repayment process. Applying for and getting your first loan is a rite of passage. It’s an important step on the exciting path of growing up!

What do lenders look for in your application? What separates the approvals from the denials? Lenders take on a risk when loaning out funds to borrowers, so they make sure to evaluate an applicant’s credit risk. Lenders are interested in getting to know who they’re lending to - this is where the 5 Cs of credit come into play. Many lenders use the 5 Cs of credit, or some variation of it, to assess a borrower’s overall financial situation. As an educated consumer, it’s helpful to learn about the process.

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First C of Credit: Character

Some call this one “character” and others go by “credit history.” Either way, the first C of credit evaluates how you have previously dealt with debt. This is your reputation, or track record in respect to your habits for paying your bills. In this first step, lenders review your credit report(s). The information detailed in your credit report varies among the different credit reporting agencies. The three major credit bureaus are Equifax, TransUnion, and Experian. Lenders may use credit reports to review how much and how often you’ve borrowed funds, and whether you’ve been paying your bills on time. These different details are used to assess the likelihood that a borrower will pay back a loan, also known as credit risk. An important factor to consider is the credit score that shows up on your credit report. There are five credit score ranges:

• Excellent: 800 – 850
• Very Good: 740 – 799
• Good: 670 – 739
• Fair: 580 – 669
• Poor: 300 – 579

There are ways to improve your credit score if you’re unsatisfied with what you see in your credit report. Learn about ways to monitor your credit score for free in one of our previous posts. A good credit score can save you money in the long run by getting approved for a low interest rate on your loan. To determine your credit score, the following five factors are assessed, with payment history being the biggest factor at 35%.

• Payment history (35%)
• Amounts owed (30%)
• Length of credit history (15%)
• Types of credit (10%)
• New credit (10%)

Second C of Credit: Capacity

Capacity is a lesser-known credit-related concept, but not less important. Essentially, it’s about how successful you are with repaying your loans. Lenders calculate your debt-to-income ratio by dividing the debts you’re currently paying off by your pre-tax income. Your employment history also comes into play. All this information will be used to figure out what your potential is to regularly make payments on the loan you’ve applied for.

If you’re curious about your capacity, you can calculate your debt-to-income ratio (DTI) on your own. First, add up all the monthly payments you’re making. For most people, this would include rent/mortgage, car payment, home internet, TV streaming services, and your mobile phone bill among others. Divide the figure you end up with by your pre-taxed monthly income. Finally, multiply that number by 100. The lower your DTI, the better it is for you to qualify for a loan.

Third C of Credit: Capital

When you’re, for example, making a down payment on a car or house, you’re putting capital towards your investment. This lowers the probability of defaulting on a loan in the future and potentially increases your odds of being approved for the loan. The amount of capital that’s invested can illustrate to the lender how serious you are about repaying the loan, which in result makes the lender feel more comfortable about approving your application. Parting with a sizable capital investment now can save you money in the long run. A good example is when applying for a mortgage, leaving a down payment of 20% helps you avoid having to purchase PMI, private mortgage insurance.

Fourth C of Credit: Collateral

Sometimes collateral is confused with capital. Capital is the money you put towards an investment, while collateral is an asset that you own and use to secure a loan. Collateral helps lenders feel more comfortable about approving a loan application because if a borrower defaults on a loan, the lender repossesses the collateral. Most of the time, the collateral used is the item that the loan is financing, such as a car or home. Secured loans are less risky so they usually come with a lower interest rate compared to unsecured loans. Of course, not all loans involve collateral, such as payday loans, because they’re considered unsecured loans. Learn all about unsecured vs. secured loans here.

For borrowers who are looking to improve their credit score, it’s a good idea to obtain secured loans and secured credit cards. Payment history accounts for 35% of your credit score. If a borrower makes regular payments in full and avoids missing any payments, their actions will be viewed as positive payment history. The great thing about having positive payment history is that it will stay on your credit report for 10 years after you’re finished paying off the loan.

Fifth C of Credit: Conditions

Conditions come in different forms, most of which a borrower can’t control. Some examples of conditions are how you intend to use the money you receive from the loan and how long you’ve been with the same employer. Other conditions are out of your hands, such as environmental and economic. Examples of these are industry trends, federal interest rates, and upcoming legislative changes. All of the different conditions examined help lenders evaluate risk.

Before applying for a loan, it might be in your best interest to consider the 5 Cs of Credit so that you can make your own assessment of your creditworthiness. This way, you can avoid any big surprises. You might even find opportunities to make improvements in advance.