When you apply for a loan, lenders must assess your credit risk—i.e., the risk to them that you will default on the loan—based on the following five factors, often referred to as “The Five Cs of Credit.”
Credit History
This first C contains the most information on you as a borrower. Your credit history consists of information provided by previous lenders that have extended credit (loans or credit cards) to you. This history is listed on your official credit report, pulled from one or more of the three credit reporting bureaus, and includes the names of previous and current lenders, types of credit you have, payment history, and credit history length. Your credit score—based on a scale of 300–850, with better scores at the higher end—will also be checked as an indicator of risk.
Capacity
Lenders need to know if you can comfortably afford the payments on the loan you applied for. They determine this by looking at your net income amount, type, and stability (payment regularity/history), sometimes through submitted paystubs or direct deposit history. Another tool lenders use to assess your credit capacity is your debt-to-income ratio (DTI), calculated as the ratio of your current credit capacity plus the new loan debt to your net income.
Collateral (for secured loans)
If you’re applying for a home or auto loan, you’re applying for a secured loan—one that’s protected by an asset and used as collateral in case you default on the loan. The item acting as collateral is usually the item you are taking the loan out to purchase. The lender will hold on to the title of the car or the deed to the house until the loan is paid in full, including interest. The lender will also evaluate the value of the collateral. Any existing debt already secured by the collateral will be subtracted from that value. The remaining equity will be a factor in the ultimate lending decision.
Capital
It’s expected that your income will be the primary way you will make loan payments; however, your capital—including savings, investments, and other assets—could be used to help repay the loan if your income decreases or you incur unexpected expenses.
Conditions
This last C refers to how you intend to use the loan as well as to factors such as the economy. This especially applies to business loans. A lender will want to see due diligence on your part to ensure the money will be used wisely to increase business income and that the market is favorable for your business to take on this additional debt.