WHAT ARE THE 5 C'S OF CREDIT?

What happens when you apply for a mortgage loan? Well, you might expect the lender will check your credit score and ask for recent paycheck stubs and other documentation. But do you know what they're really looking at and how they come to evaluate the risk of approving your loan?

In this article, let's explore the factors that many lenders use when approving or denying loans: the 5 C's of credit.

What are the 5 C's of Credit?

The 5 C's of credit are characteristics used by lenders to estimate the chance of default when a consumer applies for a loan. Many lenders have other factors that they also consider, but these five are common in most industries today.

Once you understand these factors, you can work to leverage your assets in all five categories. You have the most control over the first four C's, so focus on those if you want to qualify for a loan.

CHARACTER

A person's character refers to their personality and what personal characteristics others associate with them. For example, you might say that your sister is reliable and friendly. You associate those characteristics with her based on intimate knowledge of past behavior.

A lender only cares about your character when it comes to financial integrity. How do they know if you're financially responsible? They look at your credit report to see how you've handled money in the past. Your credit score comes into play here, but they may also look at other credit-related factors like responsible use of credit cards and the number of collections accounts.

The lower your credit score, the more negative factors featured on your credit report. A lot of late payments, delinquencies, and defaults in the past will tell a lender that you're a high risk for future default.

CAPACITY

The goal with capacity is to determine if you can afford the loan you want to secure. The lender will look at your current income and compare it to your monthly debt load. That debt load may include what you pay for rent or mortgage plus car loans, credit card payments, and other debts featured on your credit report. The higher your debt load and lower your income, the more likely a lender is to determine that you don't have the capacity for a loan.

CAPITAL

Capital looks at your investment in the purchase. How much money can you offer as a down payment? The more you can afford to put down, the lower your assumed risk of default. There are three reasons your capital investment matters:

• The more money you put on the line, the more you have to lose if you default on the loan.
• Your down payment reduces the amount of money borrowed and lowers your payment amount.
• The lender doesn't want to assume more risk than you.

COLLATERAL

Collateral is similar to capital in that it asks what you're willing to put on the line in order to secure the loan. Instead of focusing on cash upfront, collateral refers to valuable goods that the lender can collect if you default on the loan. Some loans are offered without collateral while others allow the object you're buying to serve as collateral.

For example, the lender places a lien on the home when you finance a house. You cannot sell the house until you repay the loan and clear that lien. If you default on the loan, the lender can repossess the house.

CONDITIONS

This is a general category that every lender can define for themselves. The idea is to consider a range of other factors that may determine your suitability for a specific type of loan at the current time. Some factors that lenders may focus on include:

• Job stability
• Intended purpose of loan
• Economic factors
• Federal interest rates
• Current market indicators

Every lender determines how much risk they're willing to assume when extending loans. Now that you understand the 5 C's of credit, you can work to ensure you're appealing to lenders in at least the first four categories. You may not have much control over the conditions currently impacting the market.