What Are the 5 C’s of Credit?
Learn what lenders are looking for to improve your chances of getting approved when you apply for credit
When you apply for a loan, mortgage or credit card, the lender will want to know you can pay back the money as agreed. Lenders will look at your creditworthiness, or how you’ve managed debt and whether you can take on more. One way to do this is by checking what’s called the five C’s of credit: character, capacity, capital, collateral and conditions.
Understanding these criteria may help you boost your creditworthiness and qualify for credit. Here’s what you should know.
Character refers to your credit history, or how you’ve managed debt in the past. You start developing that credit history when you take out credit cards and loans. Those lenders may report your account history to credit bureaus, which capture it in documents called credit reports. Then, companies like FICO® and VantageScore® use the information to calculate credit scores.
Lenders use credit scores and your credit reports to determine whether you qualify for a loan or credit. But each lender has different criteria for assessing your credit history. When pulling your credit reports, they’ll look at the details of your payment history and how much you’ve borrowed. They’ll also check for things like late payments, foreclosures and bankruptcies.
Lenders may also set minimum credit score requirements. Generally, a higher credit score signifies less risk for the lender. So maintaining good credit scores or improving your credit scores may help you qualify for credit in the future.
Your capacity refers to your ability to repay loans. Lenders can check 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 own DTI ratio by adding up all your monthly debt payments and dividing that by your pre-taxed monthly income. Then multiply that number by 100.
Generally, a low DTI ratio signifies less risk for the lender because it indicates you may have the capacity to take on an additional 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.
Here’s an example: If your student loan payment is $150 a month, your auto loan payment is $250 a month and your mortgage is $1,000, then your total monthly debt is $1,400. And if your gross monthly income is $5,000, here’s how you would calculate your DTI ratio: 1,400 divided by 5,000 = 0.28. You can then multiply 0.28 by 100 to get your DTI ratio as a percentage. In this example, it’s 28%.
Capital includes your savings, investments and assets that you are willing to put toward your loan. One example is the down payment to buy a home. Typically, the larger the down payment, the better your interest rate and loan terms. That’s because down payments can show the lender your level of seriousness and ability to pay back the loan.
Your household income is often the primary source for paying off your loans. But if anything unexpected happens that could affect your ability to pay them off, like a job loss, capital provides the lender with additional security.
Collateral is something you can provide as security, typically for a secured loan or secured credit card. If you can’t make payments, the lender or credit card issuer can take your collateral. Providing collateral may help you secure a loan or credit card if you don’t qualify based on your creditworthiness.
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. On a secured credit card, you’d put down a cash deposit to open the account.
Secured loans and secured credit cards are considered less risky for lenders, and they could be useful for people who are establishing, building or rebuilding their credit.
Conditions include other information that helps determine whether you qualify for credit and the terms you receive. For instance, lenders may consider these factors before lending you money:
- How you plan to use the money: A lender may be more willing to lend money for a specific purpose, as opposed to a personal loan that can be used for anything.
- External factors: Lenders may also look at conditions outside your control—like how the economy is, federal interest rates and industry trends—before providing you with credit. While you can’t control these, they allow lenders to evaluate their risk.
Why Are the 5 C’s Important?
The five C’s of credit help lenders evaluate risk and look at a borrower’s creditworthiness. They also help lenders determine how much an applicant can borrow and what their interest rate will be.
The five C’s of credit are also important for you to understand whether you want to apply for credit. You can use them as a checklist to guide your own finances:
- Character: To develop a strong credit history, always make payments on time and try to keep your credit utilization—which measures how much credit you’re using—low.
- Capacity: Only apply for the credit you need. A low DTI ratio can help show lenders you have the capacity for a new loan payment.
- Capital: Having cash on hand may help you qualify for a loan because it can indicate to lenders your level of seriousness.
- Collateral: You may need to provide collateral to take out some loans and credit cards. If you always make on-time payments and follow the loan terms, you’ll get to keep your collateral.
- Conditions: You might not have control over some of the conditions that impact your credit application. But being aware of them will give you an idea of whether you might qualify for credit.
It may be helpful to keep the five C’s of credit in mind as you build credit and work toward your financial goals. Showing a history of responsible credit use that reflects the five C’s of credit can put you in a better position to get the financing you need.
Government and private relief efforts vary by location and may have changed since this article was published. Consult a financial adviser or the relevant government agencies and private lenders for the most current information.
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