How Credit Works: The 4 Cs of Credit

You’ve probably never heard of the 4 Cs of Credit, but they can make or break your next application for a mortgage, auto loan, credit card, or personal loan. We’ll explain what the 4 Cs are and why they’re important. 

The Four Cs of Credit are important when you apply for a loan because they determine whether or not you get approved and what interest rate and costs you’ll pay. Admittedly, this is a somewhat arcane topic. However, we do think it’s valuable to understand how the four Cs work so you can get the best possible deal on your next loan.

What is Credit?

Before we dig into the Four Cs of Credit, let’s first define credit. Credit refers to the ability to borrow money or obtain goods and services with the promise of paying for them later. It works by allowing an individual or entity (such as a business or government) to borrow funds from a lender, such as a bank, lender, or credit card company, with the understanding that they will repay the borrowed money at a later date with interest.

There are two main types of credit: secured and unsecured. Secured credit requires some kind of collateral, such as a home or car. If you fail to make your payments, the lender has the right to take the collateral to repay the loan. Secured loans often have more favorable loan terms because they’re less risky from a lending standpoint.

Unsecured credit, on the other hand, does not require collateral. It’s based strictly on your creditworthiness and ability to repay. Unsecured loans usually have less favorable loan terms than secured loans, but often easier and faster to get.

Credit is typically granted based on your credit score, which is a measure of your creditworthiness based on your credit history. Your credit score takes into account factors such as payment history, credit utilization, length of credit history, and the types of credit you use.

Once credit is granted, you can use it to make purchases or obtain services. You will then be required to make regular payments – usually on a monthly basis – to repay the borrowed amount along with interest. If you fail to make your payments on time, you may be subject to penalties such as late fees or interest rate increases and your credit score will take a hit.

The 4 Cs of Credit image.
The 4 Cs of Credit have a direct impact on whether or not get approved for a mortgage and the kind of interest rate and costs you’ll pay.

What Are The Four Cs of Credit?

The Four Cs of Credit are Character, Capacity, Capital, and Collateral. These four factors are used by lenders to evaluate a borrower’s creditworthiness.

The Four Cs are important because they allow lenders to assess the creditworthiness of borrowers and to determine the terms and conditions of the credit they will offer. By evaluating a borrower’s character, capacity, capital, and collateral, lenders can determine the risk of lending to the borrower and can set an interest rate that reflects this risk.

For borrowers, understanding the Four Cs of Credit can help them improve their creditworthiness and increase their chances of being approved for credit. By maintaining a good credit history, having a stable income, building up their assets, and offering valuable collateral, borrowers can demonstrate to lenders that they are a low-risk borrower and can negotiate better terms and conditions for their credit.

  1. Capacity – Capacity refers to a borrower’s ability to repay a loan. Lenders will typically look at a borrower’s income, employment status, and debt-to-income ratio to determine their capacity to repay a loan. A borrower who has a stable income, a secure job, and a low debt-to-income ratio is seen as more capable of repaying a loan and will be more likely to be approved for credit.
  2. Capital – Capital refers to a borrower’s assets, such as savings, investments, and property. Lenders will look at a borrower’s capital to determine their ability to make a down payment and to cover any unexpected expenses that may arise. A borrower with a high level of capital is seen as less risky and will be more likely to be approved for credit. Capital isn’t a qualifying factor for most consumer loans – other than home purchase loans, of course. You usually don’t need to show money in the bank to get the typical refinance or cash out mortgage, HELOC, home equity loan, car loan, or personal loan. Capital usually only comes into play to compensate for weaknesses in the application, such as high debt-to-income ratio or low credit scores.
  3. CollateralCollateral refers to an asset that a borrower pledges as security for a loan. If the borrower is unable to repay the loan, the lender can seize the collateral to recover their losses. Lenders will typically look at the value of the collateral and the borrower’s equity in the collateral when evaluating the loan. A borrower who offers valuable collateral and has a high level of equity in the collateral is seen as less risky and will be more likely to be approved for credit. A common form of collateral is a home against which you have a mortgage loan. Car loans are secured loans as well; if you don’t make your car loan payments, the bank will repossess the car.
  4. Character – Of the Four Cs of Credit, this one is the most impactful for most borrowers. Character refers to a borrower’s reputation for paying their debts on time and their overall trustworthiness. Lenders will typically look at a borrower’s credit history, including their payment history, credit utilization, and length of credit history. A borrower with a good credit history, who has consistently made payments on time and has a low credit utilization ratio, is seen as more trustworthy and will be more likely to be approved for credit.
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The 4 Cs directly impact whether or not you’ll get approved for a new credit card or balance transfer offer.

The Most Important “C”

The 4 Cs are not used universally for every loan that you apply for. For example, most consumer mortgages and loans don’t require Capital unless you need to make a down payment.

Unsecured lenders don’t care about Collateral and often don’t care about Capital. Many unsecured lenders don’t even ask about Capacity. If they do happen to ask about your source of income, they still may not ask for proof of income.

The C that everybody cares about, however, is Character. Most lenders will not lend to you without a credit report and score. Your credit history is super important for just about any loan you apply for. Let’s dig into how your credit scores are calculated and how to keep them as strong as possible so you can get the best possible loan deal.

What Determines Your Credit Scores

Your credit scores are one of the biggest factors lenders use to determine your creditworthiness. If you have low credit scores, you may find it difficult to qualify for a loan. Even if you do qualify, you may find yourself paying much higher interest rates and fees to get the loan. The bottom line is this: the higher your credit scores, the better the deal will be on your next loan.

Credit scores range from a low of 350 to a high of 850. According to Credit.com, the average credit score in the United States was 711 in 2021. There are five main factors that influence your credit scores:

  • Payment history: 35%. As you can see, payment history is the most important factor for the most important “C” out of the Four Cs of Credit. Remember, credit falls under Character. It’s very important to lenders that you make your payments on time.
  • Credit utilization: 30%. If you have high utilization (i.e., you’re “maxed out”) on your credit cards, expect your credit scores to take a hit even if you make your payments on time. Ideally, you want to keep your utilization on credit cards below 30% of the credit limit. This is important even if you pay off your credit cards in full every month.
  • Credit age: 15%. Length of credit history contributes to good credit scores. Avoid closing old accounts unless absolutely necessary.
  • Credit mix: 10%. Lenders like to see a mix of different types of credit accounts, such as revolving (credit card) accounts and installment loans like mortgages, car loans, etc.
  • New credit: 10%. Be careful when applying for new credit cards or loans. Too many new accounts can damage your credit scores.

How Can I Improve My Credit Scores?

If you want to improve your credit scores, the most important thing is to make your payments on time. Remember, payment history is the most important factor for the most important “C” (Character) out of the Four Cs of Credit.

You’ll also want to avoid overutilizing your revolving credit. A high utilization can severely damage your credit scores even if you make your payments on time. Revolving credit includes credit cards and some times even home equity lines of credit (HELOCs). Even if you pay your credit cards and HELOC on time, having a high utilization can seriously damage your scores.

If you’d like to close a few accounts, be sure to leave older accounts open. Length of credit history contributes to good credit scores.

Be careful not to open too many new credit accounts at one time. If you’re shopping aggressively for new loans, your credit scores may take a hit.

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Your Four Cs will determine whether or not you get approved for a home improvement loan and under what terms.

Do Credit Inquiries Damage Credit Scores?

It’s important to be careful with credit inquiries, but you don’t need to be paranoid about them. It’s not a problem if you incur a few credit inquiries as you shop for the best deal on a loan. If the inquiries are for the same type of loan and they occur in a short time frame, they’re treated as one inquiry by the credit bureaus for credit scoring purposes.

Credit inquiries usually only damage your scores if you incur many of them in a short time window. You don’t want to look like you’re desperately shopping for a loan by having a lot of lenders run your credit (car dealers are notorious for this). If you do, your credit score will likely suffer.

Credit inquiries are not usually a problem as long as you don’t have an excessive number of them.

The Four Cs of Credit Impact How Much You’ll Pay for a Loan

Again, the four Cs are important because they are used by lenders to evaluate your creditworthiness. Unsurprisingly, your creditworthiness has a direct impact on whether you get approved and how much interest and costs you’ll pay.

This is why it’s important to be aware of how the Four Cs work. When you understand what lenders look for you, you know what to focus on to improve your financial profile. And when you improve your financial profile, it will be easier to get approved and get the best possible deal.

Common Credit Scores

The most common credit scores in the United States are below. Click your score to get a detailed explanation of how your score compares to the national average, what loans may be available to you, and how to improve and maintain your score.

Mike Roberts Avatar
About Mike Roberts

Mike Roberts is the founder of MyHECM.com, a published author, and a highly experienced mortgage industry veteran with over a decade of mortgage banking experience. When he's not working, he enjoys spending time with his family, skiing, camping, traveling, or reading a good book. Roberts is the author of The Reverse Mortgage Revealed: An Industry Insider’s Guide to the Reverse Mortgage, which is available on Amazon.

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