What are the 5 C’s of Credit?
The five C’s of credit include: Capital, Collateral, Capacity, Character, and Conditions.
Capital, in general terms, is one’s wealth. This wealth is determined by an accumulation of one’s assets, and these assets are things like investments, homes, property, and finances. The amount of capital that a potential borrower has is important to lenders because capital has a lot to do with collateral: the more capital a person has, the more they will be able to provide for collateral. Capital is different than net worth—net worth is a person’s capital minus their debts. For example: If I make $200,000 in a year and have about $50,000 locked up in investments with another $300,000 worth of property, my capital is about $550,000.
Collateral is a pledge to a lender that if a borrower cannot pay their debts, the lender can take away pledged assets. Collateral protects the lender in the case a loan defaults. With collateral, they will be able to seize most, if not all, of the amount (either in financial assets or physical assets) that they lent to the borrower. As mentioned before, collateral has a lot to do with capital. Hypothetically, all of a person’s capital could be used as collateral in securing a loan, though that is in most cases excessive and unnecessary.
Capacity is a person’s capability of paying a loan back. Capacity is calculated with a formula referred to as the debt income ratio. The ratio is: monthly debt payments divided by gross monthly income. However, monthly income does not just include salary—it is the income accumulated from financial investments as well. For example: if I make about $16,000 a month with another $1,000 monthly from investments, my total monthly income is $17,000. If I have $5,000 dollars of debt a month, my capacity (according to the debt income ratio) 29%. The lower the percentage, the better the chance of securing a loan.
Character is the reputation of a borrower. Character can be calculated by looking at the payment history of a borrower. If the borrower is timely on all their debt payments, a lender is more likely to give them another loan. Character is also based on word of mouth—the reputation of a borrower in his or her community is also important to a lender.
Conditions are the most ambiguous part of the five C’s because they range greatly depending on the loan situation. Conditions can include borrowers’ investment plans, business plans, terms that the lenders expects the borrower to follow, etc. Conditions tend to be more contractual than anything else.
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