What are the 5 C’s of credit?

The 5 C’s of credit are character, capacity, capital, collateral and conditions. When you apply for a loan, mortgage or credit card, lenders may use these five factors to judge how you’ve managed debt in the past and determine whether you can take on more. 

What you’ll learn:

• Character is another name for credit history, which is a snapshot of how you’ve managed credit and loans. 
• Capacity is a reference to your ability to take on new debt and pay it back on time. 
• Capital refers to assets—like cash and investments—that could help you cover loan payments if your income changes. 
• Collateral is an asset used to secure certain loans or lines of credit. 
• Conditions cover things related to the loan, like how you plan to use the money, and factors outside your control, like economic trends.

Character refers to your credit history, or how you’ve managed debt in the past. Your credit history typically starts when you first take out credit cards and loans. Those lenders may report your account history to the three major credit bureaus—Equifax®, Experian® and TransUnion®. 

The credit bureaus compile that information into credit reports. Credit reports include things like your payment history, how much you’ve borrowed, and any negative information like late payments, foreclosures and bankruptcies.

Then, companies like FICO® and VantageScore® use your credit reports to calculate your credit scores. Lenders use your credit scores and credit reports to determine credit risk and whether you qualify for a loan or line of credit.

Capacity refers to your ability to repay loans. Lenders can assess your capacity by looking at how much debt you have and comparing it to how much income you earn. This is known as your debt-to-income (DTI) ratio. You can calculate your DTI ratio using the following steps: 

1. Add up all your monthly debt payments.
2. Divide that number by your pretax monthly income.
3. Multiply the new number by 100.

Generally, a low DTI ratio signifies less risk for the lender and shows that you may have the capacity to take on another monthly debt payment. The Consumer Financial Protection Bureau recommends keeping your DTI ratio for all debts at 36% or less for homeowners and 15%-20% or less for renters.

Capital includes the savings, investments and assets that could help repay the loan. One example of how capital can affect a loan is the down payment. Typically, the larger the down payment, the lower your loan amount and the better your interest rate and loan terms. 

Here’s another reason why capital matters: Your household income is often the primary source for paying off your loans. If anything unexpected happens that could affect your ability to make payments, like a job loss, capital provides the lender with additional security.

Collateral is something you can provide to secure a loan. If you can’t make payments, the lender can take your collateral. Secured loans are typically easier to qualify for than unsecured loans because collateral reduces the risk for the lender.

The asset you provide as collateral—and whether you need it—depends on the type of credit you’re applying for. For auto loans, the car you buy usually acts as collateral. For a secured credit card, you put down a cash deposit to open the account.

Conditions help determine whether you qualify for credit and the terms you receive. For instance, lenders may consider how you plan to use the money. External factors—such as the economy, federal rates and industry trends—might also influence lenders.

The 5 C’s of credit give a sense of the things lenders use to analyze credit risk and creditworthiness. They also help lenders determine how much an applicant can borrow and what their interest rate will be.

Character, capacity, capital, collateral and conditions are the 5 C’s of credit. When you apply for credit, lenders may look at them to help determine your creditworthiness. And if you’re working on improving your credit, keeping the 5 C’s in mind can guide your financial decisions. 

If you’re considering a new credit card, you can see if you’ll be approved for a Capital One credit card with 100% certainty before you accept an offer. It’s quick, and it won’t hurt your credit scores.