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.
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.
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?
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 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.
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?
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 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.
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?
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.