What Are the Four Cs of Credit?

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When you want to borrow money, a potential creditor will take a close look at your background. As Bank of Labor’s Senior Credit Officer, Pat Thomas, notes, “This review helps banks and other creditors determine whether or not you have the means to repay the loan.”

What criteria does a lender use when assessing credit risk? Most use a framework known as the “Four Cs of Credit.” These are four common-sense areas that a creditor will review. Those four Cs are…

  • Capacity
  • Capital
  • Collateral
  • Character

Here is what lenders look at when it comes to each of these factors so you can understand how they make their decisions.

Capacity

Capacity refers to the borrower’s ability to pay back a loan. This is one of a creditor’s most important considerations when lending money. However, different creditors measure this ability in different ways. For example, lenders might analyze…

  • Debt-to-income (DTI) ratio, which is how much total debt you have relative to your income
  • The amount of revolving debt you have, such as credit card debt
  • How much your payments would be for the proposed loan relative to your gross monthly income

Lenders will ask for verification of your income and debt payments to ensure you have the capacity to take on a loan. They might require that you submit current pay stubs, past tax returns, or W2s. They will evaluate your income based on how long you’ve been employed with a company and the type of income you earn (salary, commission, freelance, etc.). 

Lenders will also review your recurring monthly expenses, such as…

  • Mortgage payments
  • Car payments
  • Student loans
  • Personal loans
  • Other debts
  • Credit card payments

Most lenders will use a DTI calculation as part of this assessment, with many preferring a ratio of 38% or less before approving financing. In fact, the Consumer Financial Protection Bureau (CFPB) reports that some lenders are prohibited from issuing loans to borrowers with high DTIs.

Capital

Lenders also consider any equity the borrower put towards their loan or purchase. A larger down payment may reduce the borrower’s chances of defaulting on the loan and give the lender more assurance.

In addition to any proposed down payment, lenders may consider components like cash flow and overall net worth. In other words, how much money do you have in investments and savings, and what portion of that is accessible if needed? Some sources of cash reserves might include…

  • Money market funds
  • Savings
  • Stocks
  • Other investments that can be converted to cash, including bonds, Certificates of Deposit (CDs), 401(k) accounts, and Individual Retirement Accounts (IRA). 

In addition to cash reserves, other sources of capital that a lender might consider include gifts from family members, grants or matching funds programs, and closing cost assistance programs. 

Lenders are likely to ask for verification of any capital. You might need to submit copies of investment statements or documentation with your loan application. Lenders may also ask to see several months’ worth of statements for your checking and savings accounts.

Collateral

Most loans require collateral. For a mortgage, the collateral would be the home; for a vehicle, it’s the car, and so on.

When a lender evaluates a loan, they consider the loan-to-value (LTV) ratio, which is the collateral’s value relative to the loan amount. For example, a 100% LTV means you are borrowing 100% of the asset’s value, likely with no down payment. 

A higher LTV is riskier for lenders. There’s always the potential that the value of an asset could fall after the loan is issued. This is particularly the case with vehicles and equipment. If you default on the loan, the lender has the legal right to repossess or foreclose on the collateral.

Most lenders will have a minimum LTV requirement to protect themselves from large losses. This often necessitates a certain down payment to lower the LTV on a potential loan.

Character 

Finally, most lenders will review a potential borrower’s character by assessing their credit history. Your credit history gives a detailed overview of how you managed debt in the past, which is a good predictor of future behavior. 

For personal loans like mortgages and car loans, lenders will obtain a report from one or more credit bureaus (Experian, Equifax, and TransUnion). These bureaus also use a program from the Fair Isaac Corporation (FICO) to assign a single score, ranging from 300 to 850, with higher scores being better.

Credit reports contain detailed information about your past borrowing activity, including whether or not you have paid loans on time and have any collection accounts, judgments, or bankruptcies. This information stays on your report for anywhere from seven to ten years. 

A good credit score is assigned based on how you manage your credit in relation to everyone else in the system. Many lenders have a minimum credit score requirement before an applicant will be considered for a loan. Your credit score can also dictate the terms you receive on your loan. 

The Other “C” of Credit

The other “C” of credit that isn’t used quite as often is “Conditions.” This refers to any external conditions surrounding the potential borrower being evaluated. In the case of a business, has the economic environment changed in any way that might impact the borrower or their industry? 

Thomas explains that conditions might also refer to how the borrower intends to use the funds. “For example,” says Thomas, “if the intended use seems significantly risky, it may impact approval of the loan.

This is far from an exhaustive list, but it should give you a better idea of how creditors assess a potential borrower before agreeing to make a loan. Each lender will have different standards, but all of them want to see that loan applicants will be able to repay any money they borrow without difficulty.

For assistance with credit questions and applications, please call Bank of Labor at 913.321.4242.