The Four C’s of Credit are guidelines used by lenders to assess a borrower’s creditworthiness:
Character: This aspect of credit assessment focuses on a borrower’s reputation and reliability in repaying debts. Lenders analyze the borrower’s credit history, including factors like payment history, length of credit history, types of credit accounts, and any outstanding debts. A positive credit history with timely payments and responsible credit use typically reflects good character, making the borrower more trustworthy in the eyes of lenders.
Capital: Capital refers to the financial resources that a borrower can put toward a loan. This includes savings, investments, and other assets that can act as a cushion or security for the lender. For example, when buying a home, the down payment is a significant part of the capital. A larger down payment indicates a stronger commitment to the loan and reduces the lender’s risk, often leading to more favorable loan terms.
Capacity: Capacity assesses the borrower’s ability to repay the loan based on their income and existing debts. Lenders calculate the debt-to-income (DTI) ratio, which compares the borrower’s monthly debt payments to their gross monthly income. A lower DTI ratio indicates a healthier financial situation and a greater capacity to handle additional debt responsibly. Lenders typically prefer borrowers with a DTI ratio below a certain threshold, as it reduces the risk of default.
Collateral: Collateral refers to assets that a borrower pledges to secure a loan. If the borrower defaults on the loan, the lender can seize and sell the collateral to recover the outstanding debt. Common examples of collateral include real estate (as in a mortgage), vehicles, investment accounts, or valuable personal property. Collateral provides a level of assurance for lenders, especially in cases where the borrower’s character, capital, or capacity might be less certain.
Together, these Four C’s provide a comprehensive framework for lenders to evaluate the risk associated with extending credit to a borrower. A strong profile across all four dimensions typically results in more favorable loan terms, such as lower interest rates and higher loan amounts, while weaknesses in any of these areas may lead to stricter lending terms or even loan denial.
