What is 3C’s of Credit? (Explained)


The credit score measures the ability of an individual to repay its outstanding debts. It comes in handy when one has to apply for a loan, credit card or bank account.

The creditworthiness of the borrower is based on his records including how much loan has been previously taken, how it has been repaid, the current status of loans and the current salary of the borrower.

The credit score is dynamic and changes either positively or negatively with the amount of debt and ability to repay. A low credit score means there are ample chances for the application being rejected or accepted with significantly high interest rates and vice versa.

However, three factors help the creditors to determine the creditworthiness of a borrower i.e. 3 C’s of credit- Character, Capital and Capacity.

1. Character

Character is a qualitative parameter and covers the reputation of the borrower. Talking eloquently, behaving politely and dressing smartly in front of the creditors is not enough. Having a strong financial history is equally important.

Investigating character means determining the kind of borrower an individual was. The creditor looks for the personal background of the borrower, his honesty, integrity, reliability, dealing with other financial institutions, how much he is financially responsible, his current salary and stability of his employment.

The lending or any other financial institutions may also ask for experience in the relevant industry in case the loan is to finance the business and also the criminal record. All of this information usually appears on the credit reports of the borrower.

These credit reports are generated by credit bureaus on the basis of FICO scores (a three digit number) and credit utilization rate (amount of credit currently using divided by available credit). These measures influence creditors on how much they should lend, for how many months and at what interest rate to the borrower.

The top three credit bureaus across the globe are Experian, TransUnion and Equifax respectively. In addition, credit reports have detailed information about the bankruptcies if any.

These reports maintain the relevant information of the borrower for a minimum of 7 years up to 10 years.

2. Capacity

When character represents the track record of the borrower, capacity gives the projection about the affordability of the borrower. Capacity is another qualitative measure to determine how much debt the borrower can handle. The creditors analyze all the income streams and their stability against the recurring debts.

In the case of start-ups, the borrower shows the complete blueprints of the business and ensures the lender about the success of the idea. They try to convince them through realistic projections of the cash flows to repay the loans.

However, for the existing businesses, it becomes essential to show the taxes filled for the last two years and interim financial statements. The creditors determine the capacity of the borrower through various tools. Out of which DTI ratio, DCSR and level of excess cash flow are worth mentioning.

The debt-to-income ratio (DTI) measures monthly debt obligations against monthly gross income. The lower the value for this ratio is the greater chances will borrower have to qualify for the debt.

Moreover, the cut-off value for DTI may vary from industry to industry. For instance, qualifying for a mortgage requires 43% or lower while 35% or less is usually preferable.

In case, the DTI ratio of a borrower is higher than the benchmark value, the individual can either go for repaying the debt or avail the opportunity of refinancing (replacing existing debt with other) under suitable terms and conditions.

While DCSR measures the ability of the borrower by dividing net operating income by total debt including the interest payments.

The income streams creditors may look for include any asset that can be used to repay the debt like personal property, investments, savings, or real estate. It further includes the capability of the borrower to generate the cash to repay debts (principal and interest) if needed.

In case, the borrower fails to pay back the debts and could not generate the required cash flow, the lender has the authority to seize the assets as the lender of the last resort. On the other hand, there are some services available that help the borrower to fill the gaps in the cash flows.

3. Capital

Creditors see the capital from two perspectives i.e. how much the borrower is worth and how much he can invest in the potential loan. They always look at how much money the borrower is ready to invest in accordance with the net worth of the business (not applicable in the case of start-up).

Any capital invested (down payments) in the potential loan by the borrower also enhances the chances of qualifying as a significant contribution reduces the chances of default.

These down payments not only help to get better interest rates as compared to others but also indicate the level of intention and seriousness of the borrower. As an individual is taking a personal risk. There is no demand for any significant amount from the lenders for down payments.

However, as a rule of thumb 25% of the financing is expected from the borrower as it is sometimes mentioned in the ads of these lending companies that they will not fund 100% of the money. 

To further analyze, the creditors used the debt-to-equity ratio (DTE). If the debt-to-equity ratio is less than the overall value of the assets in the business then the borrower will definitely qualify for the loan.

In addition, the borrower can enhance his chances by keeping all the detailed records available in time. He must have all the track records of previous investments he made in other businesses and investments others have made in his business.

Speaking to the financial advisor before the application to ensure all the criteria is met is also a good idea. Apart from DTE, in some cases, creditors may use the loan to value ratio (LTV). LTV compares the value of the loan to the appreciated value of the asset, the borrower is planning to buy.

Company, Capacity, and Capital- the 3 C’s of credit are extremely important you know now! We can clearly understand how mastering these 3 C’s of credit can help the borrower during the application process.