What are the 5 C’s of credit? How lenders evaluate credit

Lenders need a way to ensure they get their money back so that they can continue offering loans to other people. A common framework they use to evaluate applications is the “five C’s of credit”: character, capacity, capital, collateral and conditions.

Credit Karma provides free VantageScore® 3.0 credit scores and free credit reports from TransUnion and Equifax, which can help you understand your credit profile.

But the five C’s of credit can provide a more holistic picture of your ability to pay back your debt than your credit scores and credit reports alone. Knowing how lenders use the five C’s of credit can help put you in a better position when you need to apply for a loan.

• What are the five Cs of credit?
• Character: Do you have a track record of paying back what you borrow?
• Capacity: Can you afford to take on more debt?
• Capital: What do you bring to the table financially?
• Collateral: What can you offer if you can’t repay?
• Conditions: What’s the context of the loan?
• How do lenders use the five Cs, and which matters most?
• What’s next? Improving your credit
• FAQs about the 5 C’s of credit

What are the five Cs of credit?

The five C’s of credit – character, capacity, capital, collateral and conditions – are a set of criteria that lenders use to evaluate your application for credit. Here’s what each one means:

• Character: How well you’ve repaid debts in the past. 
• Capacity: How much debt you’re able to safely take on. 
• Capital: How much you already have saved up, limiting the need for financing. 
• Collateral: What the lender can take if you can’t repay the loan. 
• Conditions: What you’re using the loan for, and what the overall economic environment is doing.

Lenders use this information to decide two main things: whether you’re approved for a loan, and if you are, how much you’ll pay in financing costs. Each lender sets their own standards here, and some are stricter or more lenient than others.

Character: Do you have a track record of paying back what you borrow?

Your character – or how well you’ve repaid past debts – is often the biggest factor that lenders consider when you apply for credit.

Lenders mainly use the information on your credit reports to judge this factor, since your credit reports are, at their core, a concise record of your debts. Here’s what lenders generally look for in your credit reports:

• Payment history: How often do you make your payments on time? Do you have any late payments? If so, how many, how long ago and how late were they?
• Derogatory events: Do you have any serious derogatory marks on your reports, like foreclosures, bankruptcies or accounts in collections?
• Length of credit history: How long have your accounts been open? Showing that you can manage credit long-term is often important to lenders.

How does character impact your credit score?

Character affects your credit scores because payment history is the most important factor to your credit score calculations. It makes up about 35% of your FICO scores and 40% of your VantageScore® 3.0 score, the credit score you see on Credit Karma.

Derogatory marks on your credit reports also affect your credit scores, but their effects on your scores lessen over time, until they fall off entirely after seven to 10 years.

How can you strengthen your character for credit purposes?

Building a strong character profile is about working to improve your credit scores, and that happens when you stay on top of your payments and pay attention to what’s on your credit reports. Here are some strategies to try:

• Set up autopay on all debts and bills so you never make a late payment.
• Check your credit report for mistaken entries, and dispute any errors you find.
• Don’t open too many new accounts at once, since this can lower your average account age and make lenders think you may be overextended.

Capacity: Can you afford to take on more debt?

Your capacity shows whether you can afford the monthly payments that will come with taking on new debt. To check this, lenders will look to your debt-to-income (DTI) ratio. This measures the percentage of your income going toward your minimum debt payments each month. For example, if you bring home $4,000 each month and owe $1,000, then your DTI ratio is 25% ($1,000 / $4,000).

Lenders generally ask about your income during the application process, which they then compare to the debt information they get from your credit reports. That debt information doesn’t include daily expenses, but it may include factors like:

• Mortgages
• Car loans
• Student loans 
• Credit card minimums
• Personal loans 

Lenders have different benchmarks when it comes to acceptable DTI ratios, but in general, 36% or less is considered good.

Capital: What do you bring to the table financially?

“Capital” in the five C’s of credit refers to your financial resources. Lenders may expect you to pay a portion of your purchase upfront as a down payment, or they may just want to know that you have certain assets, such as retirement savings.

There are a few reasons for this:

• The larger your down payment, the less you’ll need to borrow.
• The more savings you have in reserve, the easier it’ll be to repay the debt if you run into problems later.

Borrowers with more financial resources available are often rewarded with better rates and higher approval odds. But if you’re struggling in this area, there are lots of strategies you can try to help you save money and earn extra income.

Collateral: What can you offer if you can’t repay?

Collateral describes something you offer to give the lender if you can’t repay the loan as agreed. It’s essentially a backup way for the lender to recoup their costs if you default. The use of collateral varies by loan type. Collateral is standard practice for some debts, like mortgages, whereas it’s not used at all with other types of debts, like student loans.

A debt that’s backed up with collateral is known as a secured debt. In comparison, an unsecured debt has no collateral attached to the debt. All things being equal, it’s often easier to get approved for a secured loan or credit card compared to an unsecured one, since the lender has a surer path to repayment. Rates may sometimes be lower for secured loans, too, reflecting this lower risk to the lender.

What counts as collateral?

When a lender offers secured loans, they’ll have a set appraisal process in place for vetting the value of your collateral, just in case they ever need to repossess it. They generally only accept certain types of things as collateral, and this can vary by loan type. Here are some collateral examples:

• Savings: Savings and investment account balances are sometimes used to secure personal loans.
• Vehicles: Auto loans are often secured by the vehicle you’re buying.
• Equipment: Companies often pledge machinery and tools for business loans.
• Real estate: Mortgages, home equity loans and lines of credit (HELOCs) and even business loans all commonly use real estate as collateral.

Conditions: What’s the context of the loan?

“Conditions” in the five C’s of credit refers to both the characteristics of the loan itself and the broader lending environment. This accounts for factors that you generally have less control over as the borrower. Those factors include:

• Loan purpose: Borrowing for a defined purpose, such as buying a home, may be easier than taking out a large loan for no set reason.
• Risk to collateral: Lenders might add extra rules for high-risk collateral, such as flood insurance requirements for homes in flood-prone areas.
• Overall economic conditions: Lenders tighten their purse strings when recessions and other challenges are going on.
• Industry-specific challenges: Lenders evaluate the overall health of the banking industry and the local economy, since this could impact your ability to repay a debt.

What can you control within credit conditions?

You can’t always control the conditions surrounding your need to borrow money. But, if you know it’s not a great time to apply for a loan, you can consider waiting for better economic conditions, if possible.

In the meantime, you can work on saving up more money or improving your credit score, which will also help your creditworthiness.

How do lenders use the five Cs, and which matters most?

Most lenders consider your character and capacity as being the most important, because those are the closest metrics to show how you’ve managed your debts in the past, and your ability to keep doing so today.

But that’s not always the case. It can vary lender by lender, and even by the type of loan you’re applying for. A mortgage lender will carefully assess your home as collateral for the loan, for example. But collateral doesn’t even enter into the equation for most personal loans, since they’re generally unsecured.

Similarly, some lenders allow you to offset perceived weaknesses with strengths in other areas. If your credit score isn’t the greatest — the “character” component, for example — many lenders will still approve your application if you have a larger-than-normal down payment.

What’s next? Improving your credit

The real value of the five C’s of credit is learning which factors you can adjust to improve your odds of success the next time you need to borrow money. Here’s a good start:

• Save more: Larger down payments mean a smaller loan size, which lenders view favorably.
• Pay down debt: Smaller debt amounts are easier to manage, and help lower your DTI ratio, as well.
• Grow your income: Higher incomes also help lower your DTI ratio and can make it easier to save up, both of which expand your access to credit.
• Check your credit reports and scores: View your TransUnion and Equifax credit reports and VantageScore® 3.0 credit score for free with Credit Karma.