The 5 c’s of credit are employed to assess the creditworthiness of the borrowers. In order to estimate whether the loan will be repaid without any hassle or there will be a default in payments, the lenders rely on the character, capacity, capital, and collateral of the borrower besides the conditions of the required loan. The 5c of credits are important because they help the lender to decide whether to go ahead with the deal or not. They are:
- Character
- Capacity
- Capital
- Collateral
- Conditions
As a first step, the applicant’s credit history is judged. Next comes the capacity of the applicant, which is their debt-to-income ratio. Capital or the amount of money already with the applicant is also assessed. Collateral or any other assets which can be used as security against the loan too is considered. Under conditions, the then interest rates, the amount to be borrowed, and the purpose of the loan is also taken into consideration.
Did you know? The 5 c’s of credit must be considered collectively and followed to receive sufficient insight to approve/ decline a transaction.
What are the Uses of 5 Cs of credit?
The five c's of credit help lenders play it safe for themselves and take informed decisions. They are able to assess the borrower’s creditworthiness and decide on the loan amount and the interest rate as well. Simultaneously, it also helps the borrower to realize whether they need to borrow money or not. A borrower too can use the 5 c’s of credit to their advantage by managing the finances accordingly.
Understanding the 5 Cs of Credit
Under the 5 C’s method, the lenders scrutinize the credit report and scores, income statement, and other relevant information about the borrower’s finances. Different aspects of the loan too are considered. Although different lenders apply different methods to find out the borrowers’ creditworthiness, most lenders while analyzing the creditworthiness depend on the 5 c's of lending method of evaluation.
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Character
This is the first link in the method of evaluating the borrower. Here the lender assesses the market reputation of a borrower in repaying debts. This information can be availed from the borrower’s credit report. The credit reports provide information about the money borrowed by the borrower earlier and whether they were repaid on time or otherwise. The information provided by the reports is retained for 7 to 10 years. The lenders can use this information to find out the borrower’s creditworthiness. Accordingly, the loans are approved. The credit score of the borrowers helps the lenders in setting the terms and rates of loans. The borrowers who have good or excellent credit usually get better loan offers than others.
Borrowers must always ascertain that the information mentioned on the credit report is precise and accurate as incorrect or negative information would prove to be detrimental. The borrowers must ensure that all payments are made within the stipulated period of time as this will secure a good reputation for on-time payments and also create a good credit score.
Capacity
This refers to the borrower’s loan repayment ability. This is done by analyzing the income of the borrower against recurring debts and evaluating the debt-to-income (DTI) ratio of the same. This ratio is calculated by dividing the total monthly debt payments of the borrower by the gross monthly income. The borrower has a better chance of qualifying for a loan if he/she has a lower DTI.
In order to improve their capacity, borrowers have to increase their salary/wages or decrease debt as lenders look for a stable income history and consistency of regular income capacity. So, maintaining a stable income will enhance your capacity and allow you maximum consideration from lenders.
Capital
Lenders also approve of any capital that a borrower puts forward for investment as this brings down the chances of default. Borrowers who have funds to make down payments receive easier mortgage loans. Down payment also affects the terms and rates of the loan. The loan has better terms and rates if a substantial down payment or capital investment is made.
It takes time to secure capital. Similarly collecting a large down payment to make a big purchase requires time, planning, and patience. In such a situation, it is always advisable to make a comparatively smaller down payment and purchase. This will prove to be advantageous as planning and waiting to collect a large down payment amount will result in the price of the asset rising significantly.
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Collateral
Collaterals make a borrower’s position strong. The lenders have the assurance that in case of default by the borrowers they can always salvage their money by repossessing the collateral. In many cases, the collateral is the object for which the loan is being taken. Usually, mortgages are secured against house properties and auto loans are secured by vehicles. Collateral loans are also referred to as secure debt. The lenders prefer these loans as it involves minimal risk. Such loans come with lower interest rates. As compared to other unsecured loans these have better terms and conditions attached.
A borrower can improve his/ her collateral by entering a specific loan agreement. Under such an agreement, the lender will place a lien on certain assets which gives him a right to recover losses in an event of default.
Conditions
Besides considering the borrower’s character, capacity, collateral, and others the lenders also mull over the prevailing conditions at the time of considering a loan. Under general conditions, a lender considers the amount of the loan, the period of employment at the current job, the performance of the company, job stability, and others. The prevailing interest rates at that time and the amount of principal affect the lender’s decision of providing the loan. How the loan amount is going to be spent by the borrower too affects the decision of the lender. Before making a decision, the lenders also consider conditions like the economic state of the country, industrial trends, changes in the legislature, and others.
Also Read: Loan Rejection and Credit Score
Conclusion
Collaterals make a borrower’s position strong. The lenders have the assurance that in case of default by the borrowers they can always salvage their money by repossessing the collateral. In many cases, the collateral is the object for which the loan is being taken. We hope this article has been of help in providing information about the 5 c’s of credit. The 5 c’s of credit are equally important and meaningful for both lenders and borrowers. If followed correctly this method guides the lenders to accurately assess the creditworthiness of a borrower, the future of the deal, and decide on the interest rate and terms of the loan.
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