Credit is a key component of your financial health. If you have strong credit, banks and lenders are more likely to approve your application. But creditworthiness extends beyond merely your FICO score. Let’s get familiarized with the Three C’s.

The Three C’s: Character, Capital, and Capacity

Assume you walk into a bank to obtain a loan. You fill out the application, provide a pile of paperwork requested by the banker, and then wait. The banker examines the documentation and informs you that your application has been declined.

Naturally, you’re curious as to why. Almost always, you will be denied because you do not meet the lender’s creditworthiness standards. Character, Capital, and Capacity are the three C’s of credit that define your creditworthiness.

Character

People of good character are morally and ethically upright. Those of good character always do the right thing for others and are true to themselves in all circumstances. This is why many lenders and banks consider a person’s character when determining their ability to repay a loan. Creditors consider your track record and dependability on past loans.

Creditors may ask the following questions to determine whether or not to lend you money.

• Do you always pay your bills on time?
• Do you have a good credit record?
• How long have you been in credit?
• How long have you been in your current job?
• How long have you been at your current residence?
• What is your credit score?

If you have previously struggled to pay your payments, have a low credit score, or do not have a consistent present salary, you may have been denied.

One of the most important aspects of this is your credit score. While your credit score attempts to provide a complete picture of your creditworthiness, it greatly favors character. According to the Fair Isaac Company, the inventor of the FICO score, your credit history or whether or not you pay your payments on time account for 35% of your credit score. The duration of your credit history or how long you’ve been using credit determines an additional 15%. In other words, your character accounts for 50% of your credit score.

Capital (also known as collateral)

Your capital is determined by the number of valuable assets you have to back up your loan. This is also referred to as collateral. Capital is a type of asset that you own. This comprises savings, investments such as stocks, and hard assets such as real estate and gold.

When you receive a mortgage, the most basic type of collateral is your home. Most people would never be approved for a $300,000 loan just on the basis of their income or credit history. Because the residence serves as collateral for the mortgage, banks can consider more people for these loans. If you don’t pay your mortgage, they can foreclose and sell the house to recuperate their losses.

Collateral or capital is also required when applying for other types of loans. If you acquire a $10,000 loan and your only asset is $100 in the bank, you only have 1% of the loan’s total worth in capital. That isn’t very enticing to the bank since if something goes wrong, you won’t be able to repay the loan. However, if you had a $50,000 stock portfolio, the bank may be more willing to lend to you since, if necessary, you could liquidate a portion of your stock portfolio to pay the loan rather than defaulting.

The bank just has one question when it comes to capital: What is the overall worth of your assets in relation to the loan amount?

Capacity

Your capacity determines how much debt you can repay. This is a balancing of your anticipated expenses, present debt repayment, and current salary. This is referred to by lenders as your “Debt to Income Ratio.” Lenders prefer to see that the amount you must pay on your debt each month (known as debt servicing) is less than 30% of your overall income.

While it can be frustrating to be rejected a loan that you require, be grateful if you were denied due to capacity. Because you don’t have that loan, you’re less likely to go into financial problems. However, it is important to assess your debts and take actions to lessen your debt load because staying at capacity is hazardous to your financial well-being.

• How much do you make now?
• What are your monthly recurring expenses?
• What are your minimum monthly payments on all of your bills (credit cards, personal loans, school loans, and any other debt you have)?
• How many children do you have?

A Parting Word from Jerome…

Lenders employ the three C’s, character, capital, and capacity, to assess your dependability, honesty, and creditworthiness. They are a terrific financial health exam for yourself.

To determine your character, consider the following: Do I have excellent financial character? Do I pay all of my payments on time? Do I have a consistent source of income?

Analyze your bank statements, investment statements, credit card statements, and other loan statements to estimate your capital, and then calculate your net worth. You determine your net worth by subtracting what you owe from what you own. If you have a positive net worth, you are in a favorable capital position. If not, debt repayment should be a top priority. Many individuals with high positive net worths find that a large percentage is equity in real estate.

Determine how much you spend on debt each month to establish your capacity. This includes minimum payments on credit cards and other debts, such as student debt, mortgage or rent, and any other payment commitments you have, but does not cover routine expenses such as utilities or groceries. Then divide that figure by your annual income. For example, if you owe $1,000 in minimum payments each month and make $4,000, you divide $1,000 by 4,000 to get .25, indicating that you are at 25% capacity.

You will gain a better understanding of the steps you need to take to become more financially stable and responsible by asking yourself these questions and performing the calculations.