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Banks and financial institutions offer a wide range of personal finance solutions. The common product suite across these entities also includes different kinds of loans, such as home loans, personal loans, auto loans and other forms of credit.

 

Before approving a loan application and disbursing the funds to a potential borrower, banks and other financial lending institutions need to ensure that the individual is capable of repaying the dues as planned. In other words, they need to be creditworthy.

 

The 5 Cs of credit help banks assess how creditworthy an applicant is. Wondering what they are? Here is a list of the five Cs of credit -

  • Character

  • Capacity 

  • Capital

  • Collateral

  • Conditions

Understanding the 5 Cs of Credit

If you are planning to borrow funds for any financial or personal goal, understanding the 5 Cs of lending is crucial. You can get to know how different aspects of your personal, professional and financial life affect your loan eligibility. So, without further ado, let’s take a closer look at what these 5 Cs are all about.

 

Character

Don’t let the word confuse you, because character here refers to your credit history. Needless to say, this is perhaps the most important factor among the 5 Cs of lending. Your credit history includes the different kinds of loans, credit cards and credit facilities you have taken so far. It also includes the details of how effectively you have repaid your dues in the past.

 

The reason lenders look into this aspect is because it tells them whether you repay your dues promptly, or whether you have a tendency to default on your payments often. This factor also accounts for whether or not you have a tendency to make partial payments instead of repaying each EMI in full.

 

The better your credit score or credit history is, the more favourable you will be considered in the lender’s point of view. A good credit history lowers the risk that you will default on your new loan.

 

Capacity

The term capacity in the five Cs of credit is simply the ability of a borrower to repay the loan they take. In other words, it helps the lender assess whether you have the financial capacity to pay back your loan EMIs as per the repayment schedule. Lenders use a metric known as the debt-to-income ratio or the DTI ratio to compute this factor.

 

The DTI ratio is simply your total debt divided by your total income. A lower DTI ratio indicates that a smaller percentage of your income is going towards repaying your current debt. This means you have greater financial capacity to take on new debts. Most financial institutions generally favour borrowers with a DTI ratio of 36% or lower. 

 

Apart from the DTI ratio, banks and financial institutions may also look at some liquidity ratios to get a better idea of your cash flow and how liquid your funds are. If your money is locked up in a fixed asset like a house or in your business, it may be difficult for you to repay your loans on time.

 

Capital

The next on the list of the 5 Cs of credit is capital. This is essentially the part of your financial requirement that you fund with your own money. In other words, it is the down payment that you make on the loan you intend to avail. The reason lenders take this factor into account is because if a borrower puts a bigger down payment on a loan, they may have a lower tendency to default on the credit facility.

 

This is one of the reasons why a borrower who puts down a larger down payment may get a loan at a more favourable rate of interest than an individual whose capital contribution is lower. That said, most lenders accept down payments that are at least 20% of the total loan value.

 

Collateral

Collateral, which is the next item on this list of 5 Cs of lending, is a kind of security that the borrower offers the lender. Typically, it is any kind of an asset that can be used by the lender to cover the risk of default. For example, if you avail a home loan, the house property that you are buying is the collateral for the loan. In case of default, the lending bank has the right to sell the collateral - aka your house — and use the sale proceeds to set off the defaulted loan amount. 

 

There are also some credit cards that rely on the concept of a collateral. These are known as secured credit cards, and to be eligible for one, all you need to do is offer a deposit in the same bank as collateral. This makes the credit facility less risky for the lender.

 

Conditions

This is a broader category that encompasses several factors. For starters, it refers to the terms and conditions of the loan, such as the repayment tenure, the amount to be borrowed, and so on. These conditions can also impact the lender’s decision to finance your requirement. In addition to these aspects, the conditions referred to in the five Cs of credit also indicate the end use purposes of the funds.

 

For instance, home loan funds should specifically be used to build or buy a house. Auto loans come with the condition that the funds should be used to purchase a new or used vehicle. And green home loans are exclusively for buying or constructing sustainable houses.

 

And lastly, this category also includes other economic conditions such as the repo rates, any industry-specific regulations or legislations, and so on. Lenders factor in all of these conditions before approving a loan.

Why Are the 5 Cs of Credit Important

The five 5 Cs of credit of credit are very important for both lenders and borrowers. This is why both parties in a loan transaction should be aware of these aspects. Check out why the 5 Cs of credit are important to the lender and the borrower.

1. Importance to the Lender

The 5 C’s of credit are important to lenders because they act as benchmarks to evaluate how risky a borrower’s profile could be. High-risk borrowers come with a greater possibility of defaulting on the loan, making it a risky transaction to enter into for the lenders. 

 

So, to make sure that the funds they lend are paid back on time, banks and financial institutions use these factors. All in all, the five Cs help lenders determine two things 

  • Whether an applicant is eligible for credit

  • The amount of credit they are eligible for

2. Importance to the Borrower

If you are a borrower who has applied for a loan or a credit facility, or if you are planning to do so, the 5 Cs of lending take on a great deal of importance for you too. If will affect the following aspects of your life -

  • Your loan eligibility

  • The amount of loan you can borrow

 

In addition to this, the five Cs also affect how quickly or not you can achieve your financial goals. This is because many goals and milestones like building or buying your dream home, paying for your children’s higher education and purchasing your preferred car may require external financing. So, since the 5 Cs of lending directly impact your eligibility for credit, they also determine the extent to which and the timeline within which you can achieve these goals.

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Conclusion

Keep an eye on your credit history, your repayment capacity, the capital in your name, the collateral you can offer and the conditions attached to the transaction. This way, you can ensure that you are always eligible for credit, making it easier for you to borrow funds in case of an emergency.

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