The Four C’s Of Credit

How the Four C's of Credit Affect Your Car Loan Application

You probably know that your credit score is important for getting a loan. However, your credit score is not the only factor that banks and other lending institutions look at when considering you for a loan. Lenders typically look at four primary factors when considering your loan application. They are…

  • Character
  • Collateral
  • Credit Score
  • Capacity

Collectively, these four factors are known as the Four C’s of Credit. Capacity is generally the most important because it determines your ability to pay back a loan. Still, lenders take all four into account when considering you for a loan.

Let’s discuss each of the four C’s.

Character

Character is the “common sense” factor that lenders look at when considering a loan application. It is your reputation as a borrower. Lenders look at your history and financial stability in the past to get a sense of how responsible you have been and how responsible you are likely to be in the future.

Unlike the other C’s of the Four C’s of Credit, character is not quantitative, meaning it cannot be measured on a scale or be directly compared to the character of others. So, for some borrowers, character can help them get a loan, since it is the factor that allows a lender to consider your unique story when considering you for a loan.

But as character is not easily quantifiable it is not usually sufficient on its own to get you a loan. Lenders look at your collateral, credit score, and capacity first and will usually consider your character only when they cannot make a clear “Yes or No” choice based on those other three factors.

Collateral

Collateral are the assets that a lender can take possession of if a borrower defaults on his/her loan. For a car loan, the collateral is usually the car itself.

When a lender gives you a car loan, they consider the loan-to-value, or LTV, of the car. The LTV is the ratio of how much you want to borrow to how much the car is actually worth on the open market. A LTV of 100% means that you are borrowing exactly as much money as the car you are buying is worth. If your LTV is more than 100%, then you are borrowing more than the car is worth, which you may do for various reasons.

Lenders consider LTVs when reviewing car loan application to limit how much they could lose in the event of a loan default. If a borrower defaults on his or her car loan, then the lender will repossess the car to try to recover the money it lost on the car loan. In other words, the car is the collateral on the loan. However, if a lender lends more money on a car loan than the car is actually worth, then it cannot recover all its losses on the loan by repossessing the car.

To protect themselves from losing to much on a loan default, lenders usually put an upper limit on how high they will allow a LTV to be on any car loans they make. If the LTV is too high on a loan application, a lender may require the prospective borrower to make a down payment to decrease the LTV.

Credit Score

Your credit score is determined by your payment history. The three credit bureaus (Equifax®, TransUnion®, and Experian®) use an advanced program from the Fair Isaac Corporation (FICO) to look at your history of payments and rank you on a scale between 300 and 850, with 300 being the worst possible and 850 being the best possible. These scores are known as FICO® Scores and only vary from one credit bureau to the next when the information the bureaus have on your credit history varies. Note, other types of credit scores exist, but most lenders use FICO Scores.

Credit scores are assigned based on how an individual pays back their debts relative to everyone else with a credit history.

For example, if you change nothing about how you handle your finances and everyone else in the economy became less financially responsible all at once, then your credit score would actually go up without you having to do anything. This relative scaling is the reason that it is all but impossible to get either a 300 or an 850 as a FICO Score.

Most FICO Scores fall around 680 on the credit spectrum, with many people having scores below and above this number.

Capacity

Of the Four C’s of Credit, capacity is often the most important. Capacity refers to a borrower’s ability to pay back his/her loan.

Obviously, your ability to pay back a loan is an important factor for a lender when considering you for a loan, but different lenders will measure this ability in different ways. When evaluating your car loan application, a lender may analyze…

  • How much debt you have compared to how much income you earn
  • How much credit card debt you have compared to your gross monthly income (your monthly income before taxes are taken out)
  • Your revolving debt (debt that you take on and pay off regularly, like credit card debt)
  • Your monthly disposable income, which is your net income (income after paying taxes) minus your monthly outgoing debt
  • How much your car payments would be compared to your monthly gross income

This list is not exhaustive, but it should give you an idea of the types of questions lenders try to answer when looking at a potential borrower’s capacity. Each lender has different standards for an applicant’s capacity, but generally lenders want to see that a loan applicant is handling his/her monthly finances well and would be able to the handle the monthly payments that would come with a car loan.

Notes:

Equifax® is a registered trademark of Equifax, Inc.
TransUnion® is a registered trademark of TransUnion, LLC.
Experian® is a registered trademark of Experian Information Solutions, Inc.
FICO® and FICO® Scores are registered trademarks of Fair Isaac Corporation.

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