Over the next two weeks, we’ll discuss the Five Cs of Credit – what they are, how they’re applied, and why they’re important to you as the borrower.
Let’s start with the what the Five Cs of Credit are. The Five Cs are five criteria that most lenders will use to measure the creditworthiness of potential borrowers. This allows lenders to get an idea of how likely a prospective borrower is to default, so they can decide what interest rate to offer, or to offer a credit or loan product at all.
Let’s start with the first C – Character. For Character, lenders are looking at your reputation and track record for repaying debts. They generally do this by looking at your credit reports and credit scores. All other factors equal, the better your credit score, and the fewer potential negative items on your credit report, the more likely you’ll be approved for a loan or credit item, and the more likely you’ll be eligible for lower interest rates. In fact, certain lenders, particularly those in the housing market, may have specific minimum credit scores needed to be eligible for their loans. We’ve talked at length about credit reports and credit scores on this site, so instead of rehashing all of those items, you can find the links to our previous posts and videos below (1, 2, 3, 4).
The next C is Capacity. Capacity measures your ability to repay a loan by looking at your income and comparing it to your installment debt. This is done chiefly by assessing your debt-to-income ratio. Your debt-to-income ratio is your total monthly debt payments divided by your gross monthly income. For instance, if you make $60,000 a year, your monthly gross income is $5000. If your car payment in $400, your personal loan payment is $300 and your mortgage payment is $1300, your total monthly debt payment would be $2000. Your debt-to-income ratio would therefore be $2000/$5000, or 40%. Generally speaking, the lower your debt-to-income ratio, the better your chances for qualifying for a loan, and certain lenders, especially in the housing market, have maximum debt-to-income ratios for a potential borrower to be eligible.
Next week we’ll return with the other three Cs of Credit!