What Are the Five Cs of Credit and Why Should You Care?
Hazy on the borrowing experience? When you’re in a tight spot, your lack of know-how is a frustrating speed bump along the way to getting funding.
Understanding the basics can go a long way to shedding light on your options. Ask yourself: what is a personal line of credit and how is it different from a loan? Once you know what sets these products apart, it’s time to find out how you might apply.
Generally, it’s all about impressing your financial institution. They’re worried about the risk they’ll take on by lending you money, and they want to see you’re good for it.
The five Cs — capacity, capital, character, collateral, and conditions — help financial institutions make this decision. Together, they give unique insights into your past borrowing behavior, current financial abilities, and long-term financial forecast.
It’s all about determining whether you’ll make good on your loan. Mastering all five may help improve your chances of being approved.
What Are the Five Cs of Credit?
Capacity is a fancy way of saying your ability to repay the line of credit. Financial institutions want to see you have enough cash on hand to make your payments on time.
When it comes to a business line of credit, a financial institution may ask to see your professional cash flow statements and liquidity ratio.
For individuals, financial institutions may crunch your debt to income ratio. This calculation determines how much of your monthly income goes towards debt and presents it as a percentage. The higher your debt to income ratio is, the bigger the risk you present to financial institutions.
This next C examines your financial assets beyond your cash at hand. It describes savings, investments, and retained earnings to name a few.
How capital factors into your line of credit depends on whether you’re applying as a business owner or individual.
In terms of business loans, it shows whether a business owner has “skin in the game”. Coined by Warren Buffet, this phrase means you have something valuable at stake.
In many situations, it means an entrepreneur has sunk considerable personal savings into getting their business up and running.
Having something to lose if things go south signals to financial institutions that you’re going to do everything you can to keep disaster at bay, including paying your bills.
What does it mean when someone says you have “character”? Generally, they think you’re honest, dependable, and responsible.
This integrity is what financial institutions are assessing when they review your character during the lending process.
Character is deeply entwined with your credit report. This report gives insights into your past borrowing behavior, telling financial institutions things like whether you pay your bills on time and how much debt you have.
This information paints a picture of your character or reputation. By looking at how you’ve handled accounts in the past, financial institutions determine how you’ll handle future debt.
Other factors that may impact your character include:
- Employment history
- Personal or professional references
- Relationship with previous financial institutions
Collateral speaks of valuable belongings (or assets) that you use to guarantee your line of credit. It acts as a backup in case you can’t repay what you owe. Financial institutions may recoup their costs by seizing these assets.
Assets may include things like real estate, vehicles, jewelry, and gold. Basically, you may use anything as collateral as long as its value is comparable to your account.
Secured vs unsecured line of credit is a simple way of defining these accounts. “Secured” means a line of credit has the security of collateral, while unsecured does not.
Last but not least, conditions can mean a few things. It may describe the literal conditions of your line of credit. It may also be a litmus test of your financial stability or strength. And finally, it may consider the economic or industry-specific conditions that may impact your ability to repay.
What it comes down to is this: financial institutions want to get back the money they give out. Many of them will only lend money under favorable conditions.
How Are They Calculated?
Simply put, there is no standardized calculation. Unlike the five factors of your credit score — a numerical equation that breaks down your score into percentages — the five Cs have no strict rules for how financial institutions may apply them to your application.
It’s an ad hoc process that varies between financial institutions. Some may weigh all five Cs equally, while others may focus on one more than others. It may also depend on the product.
Take an unsecured line of credit, for instance. By definition, an unsecured line of credit is underwritten by your creditworthiness, not the guarantee of an asset.
In this example, a financial institution would value your character (or your credit score) over collateral.
But if you were applying for a secured line of credit, their priorities would be reversed. The belongings you put up as a guarantee may outweigh a less-than-perfect score.
What Does This Mean for Your Next Application?
At the end of the day, the five Cs give the scoop on you, the borrower. Each one provides insight into a niche chapter of your finances, and together, they combine to create your financial story.
What will yours tell?
If you want to learn more, start by getting a credit report. This will shine some light on your status in terms of character. Then consider the remaining Cs to see how you shape up. If you don’t like what you see, take control and nurture your capacity, capital, character, collateral, and conditions.
We hope you enjoyed this promoted piece as much as we did!