Three C’s of Credit: Meaning & Use in Credit Analysis (2024)

Credit scores quantify a consumer’s reliability to repay debt based on metrics like payment history and credit mix. These metrics work because they’re numerical and universal, but used alone they misrepresent borrower worthiness. That’s why there are other factors.

The three C’s of credit used to contextualize borrower worthiness are Capacity, Collateral, and Character. They underscore creditworthiness as a measure of income and saleable assets in addition to reliability and integrity.

The three C’s help lenders determine borrower riskiness before approving loans or credit cards.

Contents

Character

Character is a measure of borrowers demonstrated reliability to pay back what they owe. It’s distinct from their ability because some borrowers have the means to pay but are forgetful or unaware of their obligations. Character is like lending money to a thoughtful friend rather than a forgetful one. Of the three, character is most important for building credit fast because it takes time to create and only one mistake to blemish.

Key Questions

Some questions lenders ask to determine borrower character include:

  • What is the person’s credit score (FICO score)?
  • Has the person been condemned for a crime?
  • Does the person have strong references?
  • Have the person used credit before?
  • Do the person pay their bills on time?
  • How long has the person lived at thier present address?
  • How long has the person lived at their present job?

Example

Imagine a successful business owner with 10 credit cards who regularly misses her payments. She has the money to repay but doesn’t prioritize making the payments. She would score “low” on a character assessment because lenders cannot depend on her.

This can be confusing because those with vast amounts of wealth typically find funding. If they’re poor money managers, they rely on collateral, which we’ll look at later.

Capacity

Capacity refers to a borrower’s ability to repay credit using income. Income must be both sufficient and stable. It can come from work, investments, royalties, alimony, child support, or any other source.

Capacity also examines expenses, such as dependents (children), rent or mortgage, and cost of food and education in the borrowers area. Even extremely high earners can live paycheck to paycheck if their expenses are too high.

Key Questions

Questions lenders ask to test borrower capacity include:

  • Do the have a steady job?
  • If so, what is the salary?
  • How many other loan payments does the person have?
  • What are the person’s current living expenses?
  • What are the person’s current debts?
  • How many dependents does the person have?

Example

Imagine an investment banker who makes $450,000/year. He is paying down a house worth at $20k per month and has 4 children in private school with a wife who does not work. They’re living paycheck-to-paycheck. Though he makes a 1% salary, he doesn’t have the capacity for any more debt.

Collateral

Collateral refers to a borrower’s assets that could be sold to pay the credit, or simply confiscated if highly illiquid. Collateral can be part of the loan agreement, as is the case with mortgages, or it can simply be an inventory of saleable assets the lender collects to understand its coverage of risk. In most cases the collateral needs to be defined in the loan agreement, such as deposits on credit builder loans or secured credit cards.

Key Questions

Some questions lenders ask borrowers to assess their Collateral value include:

  • What property does the person own that can secure the loan?
  • Do the person have a savings account?
  • Does the person have investments or bonds to sell in case of default?
  • How many vehicles does the person own, and how old are they?
  • Does the person have jewelry, art, or precious metals such as gold and silver?

Example

Imagine a 55 years old small business owner with a $65,000 yearly salary. He would like to purchase a home but his income only covers living expenses and the mortgage by a small amount. If he ran into any issues such as car repair, he could be at risk of default.

However, he has steadily contributed to a IRA and taxable brokerage account for over 30 years and has sizeable investments worth more than the loan. If ever at risk, he could liquidate these quickly to make his mortgage payments. He therefore scores well in the Collateral assessment.

Capacity vs Collateral

At first glance, capacity and collateral seem like the same thing. Capacity is a borrower’s ability to repay a loan, so why does it matter if his/her money comes from income or from selling assets? The difference is liquidity.

Income is highly liquid and can be transferred immediately upon deposit. However, some assets are difficult to sell and require time. A lender does not always have the skills to sell assets, so they don’t want to confiscate them either.

For example, an art collector may have hundreds of thousands in paintings but defaults on her loans. She cannot quickly sell the pieces because though valuable, the sales cycle for them requires several months. Her bank does not know how to sell art, and doesn’t want to confiscate it because it would remain illiquide in a vault.

Imagine you loan a friend $1,000, and he want to pay you back with his vintage motorcycle. If you don’t know anything about motorcycles or how to sell them, even if the machine is worth $1,500 you just don’t want to take the risk.

Because of liquidity, collateral is “worth less” to lenders than art is.

Assets Less Liabilities

One other important point about collateral is liabilities. While an individual may have significant assets, in many cases they’re backed by liabilities that reduce the net value of the asset. For example, when a person purchases a home they do not immediately own it because they owe the bank a mortgage. A lender therefore considers the net value of a borrower’s assets under his Collateral assessment.

Three C’s to Quantitative Metrics

In practice, the three C’s translate to approval thresholds. In most cases, character requires a minimum FICO score, capacity requires a percent excess income over the loan monthly payment, and collateral is either required for some loans and for others is not (for an amount equal to the loan).

For example, lenders often require a minimum FICO 8 score of 680, and they allow loans that only represent 40% or less of the borrowers monthly income. For mortgages, the house itself represents collateral. For many personal loans, however, there is no collateral requirement.

About the Author

Noah

Noah is the founder & Editor-in-Chief at AnalystAnswers. He is a transatlantic professional and entrepreneur with 5+ years of corporate finance and data analytics experience, as well as 3+ years in consumer financial products and business software. He started AnalystAnswers to provide aspiring professionals with accessible explanations of otherwise dense finance and data concepts. Noah believes everyone can benefit from an analytical mindset in growing digital world. When he's not busy at work, Noah likes to explore new European cities, exercise, and spend time with friends and family.

LinkedIn

I am an expert in finance and credit assessment, with a deep understanding of credit scores and the factors that contribute to determining borrower worthiness. My expertise is rooted in over 5 years of corporate finance and data analytics experience, coupled with an additional 3+ years in consumer financial products and business software. As the founder and Editor-in-Chief at AnalystAnswers, I have dedicated my career to providing accessible explanations of complex finance and data concepts, believing that everyone can benefit from an analytical mindset in our growing digital world.

Now, let's delve into the concepts discussed in the provided article on credit scores and the three C's of credit: Capacity, Collateral, and Character.

Character: Character is a measure of a borrower's demonstrated reliability to pay back debts. It emphasizes reliability and integrity, distinct from the borrower's ability to pay. Key questions lenders ask include:

  • What is the person's credit score (FICO score)?
  • Has the person been condemned for a crime?
  • Does the person have strong references?
  • Has the person used credit before?
  • Does the person pay their bills on time?
  • How long has the person lived at their present address?
  • How long has the person lived at their present job?

Example: Consider a successful business owner with 10 credit cards who regularly misses payments, even though she has the means to repay. This individual would score "low" on a character assessment due to unreliability.

Capacity: Capacity refers to a borrower's ability to repay credit using income. It evaluates both the sufficiency and stability of income. Key questions include:

  • Does the person have a steady job?
  • What is the salary?
  • How many other loan payments does the person have?
  • What are the person's current living expenses?
  • What are the person's current debts?
  • How many dependents does the person have?

Example: Imagine an investment banker with a high income but living paycheck-to-paycheck due to substantial expenses. Despite a high salary, this individual may not have the capacity for additional debt.

Collateral: Collateral involves a borrower's assets that could be sold to repay credit. Key questions for assessing collateral value include:

  • What property does the person own that can secure the loan?
  • Does the person have a savings account?
  • Does the person have investments or bonds to sell in case of default?
  • How many vehicles does the person own, and how old are they?
  • Does the person have jewelry, art, or precious metals?

Example: A small business owner with limited income but substantial investments may score well in the collateral assessment. The value of assets that can be sold quickly in case of default is crucial.

Capacity vs Collateral: Capacity is the borrower's ability to repay through income, while collateral involves assets that could be sold. The key difference lies in liquidity. Income is highly liquid, while some assets may require time to sell. Lenders may not want to confiscate illiquid assets.

Assets Less Liabilities: Consideration of liabilities is crucial in collateral assessment. Significant assets may be backed by liabilities, reducing the net value. For example, a home is not immediately owned by a person with a mortgage; the lender considers the net value under the collateral assessment.

Three C's to Quantitative Metrics: In practice, the three C's translate to approval thresholds. Character may require a minimum FICO score, capacity requires a percent excess income over the loan monthly payment, and collateral may or may not be required, depending on the type of loan.

This comprehensive understanding of credit assessment concepts is essential for both borrowers and lenders in navigating the complexities of financial transactions.

Three C’s of Credit: Meaning & Use in Credit Analysis (2024)

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