If you are about to purchase a home, you must understand the importance of the 5 Cs of credit. The five Cs of credit is a framework lenders use to assess the creditworthiness of potential borrowers. This system evaluates five key characteristics of the borrower and the loan's conditions, aiming to estimate the likelihood of default and, therefore, the potential financial risk for the lender. The five Cs of credit include character, capacity, capital, collateral, and conditions.
- Character is assessed by your credit history. Lenders will review your credit report from Equifax, Experian, and TransUnion which provides a snapshot into a borrower’s track record for repaying debts. These reports often contain records dating back seven to 10 years. Lenders also look at the overall credit score known as your FICO score. This score ranges from 300-850. A score of 670 and higher indicates a “good” credit score, but some lenders may have flexibility regarding the needed credit score.
- Capacity refers to the debt-to-income (DTI) ratio. DTI is calculated by taking total monthly debt payments divided by gross monthly income. A lower DTI gives the borrower a better chance of qualifying for a loan. If your DTI is too high, start paying down existing debt, make payments on time, and increase your income.
- Capital refers to any contribution that the borrower invests in a potential opportunity like a down payment. When the borrower makes a significant capital contribution, it reduces the likelihood of default.
- Collateral is used to help a borrower secure a loan. Collateral is the home you are purchasing or refinancing. An appraisal will ensure that the home has the appropriate value and condition to secure the loan. If a home is not safe and sound for living the other 4 Cs can’t compensate for inadequate collateral.
- Conditions encompass many variables. Lenders may review the length of time that an applicant has been employed at their current job, the state of the economy, industry trends, and financial circumstances.
In summary, while all five Cs are integral to the credit evaluation process, lenders may prioritize them differently based on the current economic climate, the nature of the loan, and the specifics of the borrower’s situation. This nuanced approach allows lenders to make informed decisions that balance risk and opportunity.