Have you ever wondered what a banker considers before approving your mortgage, car loan, or credit card? When you apply, lenders evaluate the risk of lending you money by weighing four core key factors known as Credit 4 Cs: Character, Capacity, Capital, and Collateral. In this post, we’ll break down each factor to help you understand a banker’s mindset—and possibly increase the chances of hearing “yes” more often than “no.”
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What are the 4Cs of Credit?
- Capacity to pay the loan back
- Capital
- Collateral
- Character (Credit score)
Why are the 4 Cs of Credit Important?
The 4 Cs of credit matter because they give lenders a complete picture of your financial stability and trustworthiness. Evaluating Character, Capacity, Capital, and Collateral helps them assess the risk of lending to you and decide on loan approval. Knowing these factors can improve your chances of securing financing.
What is Capacity?
Capacity is all about figuring out whether you can repay a loan. Lenders check your gross monthly income, job history, savings, and current debt payments. They calculate your debt-to-income (DTI) ratio by dividing your monthly debt payments and dividing them by your gross income. This gives them a clear picture of your financial situation and helps them see how likely you are to handle new debt smoothly.
What is Capital?
Capital means the cash reserves and valuable stuff you have that can easily be turned into money, like savings, investment accounts, and other assets you can sell quickly. For personal-loan applications, this includes the balances in your savings or investment accounts.
Lenders look at your capital to see if you have extra resources to cover the loan if your income or revenue takes a hit while you’re still paying it off. Essentially, your capital helps them gauge your overall financial stability and how well you can handle loan payments even if things don’t go as planned.
What is Collateral?
Collateral, as part of the 4 Cs of credit, is the valuable asset you use to back up a loan. It gives lenders something to fall back on if you can’t repay the loan. For instance, with an auto loan, the car is the collateral, and with a mortgage, the home serves as collateral. That’s why these are often called secured loans.
Lenders check the value of this collateral to make sure it’s enough to cover the loan if things go wrong. This helps them gauge the risk and figure out if they’ll get their money back. Just to be clear, not all loans have collateral. Those are called unsecured loans and usually come with higher interest rates, especially if your credit score isn’t great.
What is Character?
Character, the first C of credit, is all about your credit history and how well you manage debt, which shows up in your credit score. If your score is low and you can’t explain missed payments or defaults, it can be a red flag for lenders. We look at your payment history, how much you owe, the length of your credit history, and the types of credit you have using data from credit bureaus like TransUnion.
Your score, which ranges from 300 to 850, affects your chances of getting a loan, the interest rates you’ll be offered, and even things like renting an apartment or getting certain jobs. A poor credit score can lead to higher interest rates and tougher loan terms even if you have solid capital and good repayment capacity.
What is a good credit score?
Your overall credit score and credit history is one of the main factors mortgage lenders evaluate when determining loan terms.
Borrowers with higher scores are seen as lower risk and are more likely to receive lower interest rates on their home loans, ultimately saving money. So, improving your credit score and maintaining a good track record is a good idea before you dive into the housing market.
There are three main credit reporting bureaus—Experian, Equifax, and TransUnion. Each independently reports your score, so there may be slight differences between the bureaus.
Generalizations of score ranges:
- 720 – 850 = excellent credit
- 690 – 719 = good credit
- 630 – 689 = fair credit
- 350 – 629 = poor credit
In 2023, the average FICO Score in the U.S. stood at 715.
How does credit affect your mortgage rate?
our credit score plays a critical role in determining your mortgage loan rate. Mortgage lenders assess a borrower’s creditworthiness based on factors like credit history, financial obligations, and sources of income.
Home loan lenders, traditional banks, and other financial institutions view higher credit scores as a lower risk. A solid credit history indicates you’re more likely to make consistent payments and less likely to default. I recently checked out MyFICO’s Loan Savings Calculator, and the numbers were pretty surprising (see table below).
MyFICO data table:
A small increase in your credit score can lead to significant savings. For example, improving your score from 695 to 705 could save you $10,000 in interest over the life of your mortgage.
What if I have a low credit score?
According to NerdWallet, even with a relatively low credit score, you might still qualify for various types of loans. Some lenders have low minimum credit score requirements. For example, you can get FHA loans with a score of at least 500, VA loan lenders usually prefer scores of 620 or higher, and USDA loans typically need a score of at least 640. While you’ll still need to meet the other requirements for these loans, there are options available if your credit score isn’t perfect.
How can I improve my chances of getting a mortgage?
In other words, what can you do to improve your capacity, capital, character (credit score, and Capacity? )
Capacity
Earning more money is the best way to improve your capacity to repay a mortgage. A higher income makes you more attractive to banks. Consider getting a second job, joining the gig economy, asking for a raise, switching to a better-paying company, or even changing careers. If increasing your income isn’t feasible, look into buying a smaller house or borrowing a smaller amount. A smaller loan means lower monthly payments, which might be easier to manage with your current income.
Capital
Improving this aspect of the 4 Cs involves saving more each month. Aim for a down payment of at least 20% if possible. This reduces the amount you need to borrow and strengthens your mortgage application.
If saving the full 20% isn’t practical due to urgent housing needs or a competitive rental market, a larger down payment can help your mortgage application and improve your overall position.
Collateral
When applying for a mortgage, ensure the property appraises for at least the mortgage amount, as lenders won’t approve a loan above the appraised value. In a hot real estate market where homes sell above the asking price, getting approved for a large mortgage quickly can be tough. Do you know what helps? Having substantial cash reserves.
Credit score
Reducing your credit utilization to below 30% of your available credit—ideally 0%—can significantly improve your credit score. Pay your bills on time, keep debt low, and monitor your credit card balances regularly. Also, check your credit report for mistakes and resolve any negative entries. Consistent, responsible credit use builds trust with lenders over time.
Are credit counseling services legit?
Yes, there are genuine credit counseling agencies that can be helpful, but many are scams that just take your money without offering real assistance. Start with the National Foundation for Credit Counseling, a nonprofit that offers free help from certified credit counselors. Avoid paying for credit counseling services, as many companies that claim to improve your credit score are simply trying to take your money.
What are you doing to improve YOUR 4 Cs of credit?
Looking at things from a banker’s perspective can help you get approved for business credit, personal loans, car loans, and mortgages—or figure out why you weren’t approved. To improve your financial health, pay attention to it every month. Regularly check your credit score, and if it’s not where you want it to be, take steps to improve it. Your credit report reflects your character, but don’t ignore the other Cs of credit: capital, capacity, and collateral.
Thank you for these simple explanations. We have a kind of adopted adult daughter who desperately needs to better understand credit and work to grow hers. Great ideas here!