What are The Four C’s of Credit?
Everyone knows that their credit score is crucial for getting a loan, especially one with a low interest rate. However, your credit score is not the only factor that banks and other lending institutions look at when considering you for a loan. Often times, lenders look at four primary factors when considering your loan application. They are…
These four factors are known as the “Four C’s of Credit”. Let’s take a look at each of the four C’s.
Character is the “common sense” factor that lenders look at when considering a loan application. It is your reputation as a borrower. Lenders look at your history and financial stability in the past to get a sense of how responsible you have been and how responsible you are likely to be in the future.
Unlike the other C’s of the Four C’s of Credit, character is not quantitative, meaning it cannot be measured on a scale or be directly compared to other’s character. So, for some borrowers, character can help them get a loan, since it shows a track record of payments.
Since character is not easily quantifiable it is not usually sufficient on its own to get you a loan. Lenders look at your collateral, credit score, and capacity first and will usually consider your character only when they cannot make a clear “Yes or No” choice based on those other three factors.
Collateral are the assets that a lender can take possession of if a borrower defaults on his/her loan. For a car loan, the collateral is the car itself.
When a lender gives you an auto loan, they consider the loan-to-value, or LTV, of the car. The LTV is the ratio of how much you want to borrow to how much the car is actually worth on the open market. A LTV of 100% means that you are borrowing exactly as much money as the car you are buying is worth. If your LTV is more than 100%, then you are borrowing more than the car is worth. It is not uncommon to have a LTV over 100% when financing fees such as DMV and documentation fees.
Lenders use LTV when considering a car loan application because if a borrower defaults, then the lender will repossess the car to try to recover the money it lost on the car loan. In other words, the vehicle is the collateral on the loan.
However, if a lender lends more money on a car loan than the car is actually worth, then it cannot recover all its losses on the loan by repossessing the car. For this reason, lenders sometimes put a limit on how high they will allow an LTV to be. If the LTV is too high on a loan application, a lender may require the prospective borrower to make a down payment to decrease the LTV. The average LTV limit allowed for 60-month auto loans is 130%.
Your credit score is determined by your payment history. The three credit bureaus (Equifax®, TransUnion®, and Experian®) use an advanced program from the Fair Isaac Corporation (FICO) to look at your history of payments and rank you on a scale between 300 and 900, with 300 being the worst possible and 900 being the best possible. These scores are known as FICO® Scores and only vary from one credit bureau to the next when the information the bureaus have on your credit history varies.
The important thing to understand about credit scores is that they are assigned based on how an individual pays their debts relative to everyone else with a credit history. For example, if you change nothing about how you handle your finances and everyone else in the economy became less financially responsible all at once, then your credit score would actually go up without you having to do anything.
Most FICO Scores fall around 680 on the credit spectrum, with many people having scores below and above this number.
Of the Four C’s of Credit, capacity is often the most important. Capacity refers to a borrower’s ability to pay back his/her loan. When lenders see you have paid your debt on time over 90% of the time, your capacity goes up and the risk for the auto lender goes down. This greatly affects your FICO Score.
Obviously, your ability to pay back a loan is an important factor for a lender when considering you for a loan, but different lenders will measure this ability in different ways. When considering you for a car loan, a lender may consider…
How much debt you have compared to how much income you earn.
How much credit card debt you have compared to your gross monthly income (your monthly income before taxes are taken out) otherwise known as the “debt to income ratio”.Your revolving debt.
Your monthly disposable income, which is your net income.
How much your car payments would compare to your monthly gross income.
This list should give you an idea of the types of questions lenders try to answer when looking at your borrowing capacity. Each lender has different standards for an applicant’s capacity, but generally lenders want to see that a loan applicant is handling his/her monthly finances well and would be able to the handle the monthly payments that he/she is applying for.