Finance & Career
Lenders assess your creditworthiness to determine whether you qualify for a loan or credit card. Your creditworthiness measures how responsible you are in managing and repaying your debt. It also provides evidence (past failures and successes) to help lenders decide whether to extend credit to you. In other words, your creditworthiness is one indicator that determines whether you can be trusted with money or other financial resources.
There are various factors used to assess creditworthiness or the likelihood of you repaying a loan. Knowing these factors in advance can help you to boost your creditworthiness. These factors are better known as the “five Cs of credit.”
The 5 Cs of Credit
Character refers to your reputation or track record for repaying debt. This is also known as your credit history. Lenders use your credit report and credit score to determine how responsibly you manage your debt. The higher your credit score, which is determined from your credit report, the greater the likelihood of you repaying a loan. The lower your credit score, the greater the likelihood of you not repaying the loan. Remember your credit history— which accounts for 35 percent of your credit score—determines your financial character.
Capital is the cash you must pay toward an investment. In other words: the down payment. Capital is the amount you contribute or put towards purchasing an item. The amount you provide will often show your level of seriousness. The larger the amount you put towards an investment, then the more likely lenders will secure a line of credit. A larger down payment means less money borrowed, and less money borrowed means reduced risk for the lender.
Collateral is different from capital. It refers to the assets you use to secure a loan. For example, you may use your boat as collateral for a personal loan. The boat secures the loan. This means that if you fail to repay the loan as stipulated in the agreement, your boat will become the lender’s property. When purchasing a car or a home, the car or the house itself is the asset that secures the loan. Remember, the bank or the lender has the right to keep the asset (collateral) if you fail to pay off the loan.
Capacity is your ability to repay a loan. In determining your capacity to repay the money you are requesting, lenders will often calculate your debt-to-income (DTI) ratio to get an indication of how much of your income is being used towards your debt. To calculate your DTI: calculate your monthly expenses, divide your total expenses by your total monthly income (before tax), and then multiply by 100. The lower your DTI ratio, the greater your creditworthiness, or the more assured lenders are that you can afford to repay the loan.
Conditions are the terms of a loan the lender considers before lending you the money. Current interest rates, the amount requested, and the value of the asset you are purchasing may be considered in a lending decision. Usually, the conditions considered are not under your control.
Knowing what you can do to improve your creditworthiness begins by doing the following:
- Be consistent in paying your bills on time and in full.
- Keep your credit card balances under 30 percent of the credit limit. For example, if your credit limit is $1,000, don’t charge anything over $300. Your credit score drops when your credit usage exceeds 30 percent of your credit limit.
- Know what is on your credit report. You can request your credit report at annualcreditreport.com.
- Save money to make a larger down payment.
Knowing the five Cs of creditworthiness can help you understand how and why lenders approve or deny loans. Improving your creditworthiness will improve your chances of being approved for a loan and help you save money by obtaining lower interest rates. Likewise, improving your credit score by building and maintaining good credit can help you improve your creditworthiness.