Five Cs of credit

The five Cs of credit are character, capacity, CAPITAL, collateral, and conditions. To analyze the risk of DEFAULT by a borrower, lenders typically evaluate a customer’s five Cs. Character refers to a borrower’s integrity, credit history, and past relationships with the lender. Credit history is an important determinant in predicting whether a borrower will default or not. In the United States, three major CREDIT-REPORTING SERVICES provide lenders with information about customers’ past credit experiences. Capacity is the borrower’s ability to pay off the loan requested. Lenders often use ratios of loan payment to monthly INCOME and total monthly payments to income in evaluating a borrower’s ability to pay. Capital is a borrower’s net worth or WEALTH, some of which may be offered as collateral against a loan. Collateral is comprised of ASSETS that the lender could seize and sell if the borrower defaulted on the loan. Conditions refer to ECONOMIC CONDITIONS. Lenders know from experience that borrowers’ ability and likelihood of paying off LOANS are influenced by changes in the economy. U.S. banking institutions are regulated by state banking commissions or the FEDERAL RESERVE SYSTEM. During declining economic conditions, regulatory authorities often examine more closely how lenders apply the five Cs of credit in making loan decisions. By the nature of their business, banks and other lending institutions consider borrowers their most important customers. Generally lenders can attract deposits or capital by offering competitive INTEREST RATES. Finding good borrowers is more difficult. Lenders make a PROFIT by the spread, the difference between the cost of funds and the rate being received for LOANS or INVESTMENTS. Because lenders are RISK-averse, borrowers whose five Cs indicate a higher potential for default are charged higher interest rates, compensating lenders for the higher percentage of defaults. During the 1990s many U.S. lending institutions made money through credit-card lending to low-quality customers at very high interest rates.