To qualify for a loan, you should convince a lender of your ability to repay a debt. Lenders will typically gauge that ability by looking at your creditworthiness and credit score. They will get your credit report from a credit reference bureau (CRB) and use the information they receive to build an accurate credit risk profile.
The profile they create will determine how much you qualify for and if you will be approved for a loan amount. Many factors go into determining your credit limit and loan approval. The factors that lenders use to evaluate your borrowing strength are collectively known as the 5 Cs of Credit.
According to the Central Bank of Kenya’s Credit Reference Bureau Data Standards Manual, the 5 Cs of credit are essential features for underwriting, i.e., assessing the borrower's creditworthiness. Therefore, you can qualify for higher loans by improving these five factors.
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Understanding The 5 Cs of Credit
The 5 Cs of credit are the framework banks and other lending institutions utilise to assess the borrower's creditworthiness and overall strength when making a loan application. It enables lenders to evaluate factors such as the borrower's ability to repay the loan, their credit history, and the level of risk associated with the borrowing request.
These Cs include Character, Capacity, Capital, Collateral, and Conditions. Each factor represents an important aspect of a borrower's financial profile.
To build credit and qualify for higher loans, you need to know how the 5 Cs of Credit can affect your creditworthiness and how to use these five factors to strengthen your credit.
These 5 Cs of Credit provide a comprehensive view of a borrower's creditworthiness. Therefore you must learn how the CBK defines each factor for the lenders if you are to use them to your advantage.
Let's take a closer look at each of these elements and why they matter:
- Character: This refers to the borrower's track record of integrity in payment behaviour and credit usage. Essentially, it's a measure of how trustworthy the borrower is. To determine their character level, lenders will look at the borrower's credit history, including their payment history and any outstanding debts.
- Capacity: This refers to the borrower's ability to afford the loan. Lenders will look at the borrower's cash flow or income to ensure that they have enough money coming in to service the loan. If the borrower's income is insufficient, they may be deemed too risky to lend to.
- Capital: This refers to the borrower's net worth or assets. Lenders will look at the borrower's financial situation to determine if they have enough assets to cover the loan in case of default. If the borrower has significant investments, they may be seen as less risky to lend to.
- Collateral: This refers to the value of assets the borrower can offer as security for the loan. Lenders will typically require collateral to mitigate their risk in case of default. The value of the collateral will be evaluated to ensure that it is sufficient to cover the loan amount.
- Conditions: This refers to the borrower's overall financial situation and the economic landscape. Lenders will look at factors such as the borrower's industry, the state of the economy, and any other relevant circumstances that could impact the borrower's ability to repay the loan.
Now that you understand how the 5 Cs of Credit work, how can you improve yours?
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Improve Your Character
Your credit history defines your financial reputation, which lenders use to decide if you're trustworthy enough to repay a loan. So, if you have a history of late payments, defaulting, or misusing loans, this information will be included in your credit report.
But don't worry. You can take steps to improve your credit character and increase your chances of getting approved for loans. Here are three things you should do:
- Repay loans on time and in full: Timely and full repayment is a great way to demonstrate that you are responsible and reliable. This practice helps build your credit score and sends a positive signal to lenders.
- Constantly review your CRB report and get a clearance certificate: Check your credit report regularly and ensure that all the information is accurate. Consider obtaining a clearance certificate from a CRB, and If you notice any discrepancies, correct them before approaching a lender.
- Use your credit responsibly and avoid bad credit-building tactics: Don't borrow over your limit or exhibit loan dependency. If you use credit cards, pay your bill on time, and if you can't, always ensure to pay the minimum amount. Finally, avoid tactics like co-signing for someone with bad credit or taking out multiple loans simultaneously.
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Improve Your Capacity
To improve your credit capacity, show a lender your ability to repay a loan. Lenders will look at your salary, existing loans, and income stability to determine your capacity.
Are you employed in an occupation likely to provide enough income to service a loan? Are you self-employed?
To improve your credit capacity, you should:
- Lower Your DTI: One of the primary factors lenders consider when evaluating your credit capacity is your debt-to-income ratio (DTI). This is the percentage of your monthly income that goes toward paying off debts. The lower your DTI, the better your credit capacity. So, work on increasing your income and paying off any existing debts to lower your DTI.
- Have Multiple Sources of Income: If you're self-employed or work in a job that doesn't offer stable income, having multiple sources of income can help show lenders that you have a steady stream of money coming in. This can include things like rental income, freelance work, or a part-time job. By demonstrating stability in your income, you can improve your credit capacity and increase your chances of getting approved for a loan
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Improve Your Capital
Capital can be considered your overall financial strength. It shows what other unencumbered assets (or sources of cash) may be available to support debt repayment. A lender will want to know if you have valuable assets such as real estate, personal property, investments, or savings to repay the debt if income is unavailable.
For instance, can you service the loan if you lose your income?
Capital is different from collateral. Lenders will consider your capital, but you won’t transfer it to them when borrowing.
To improve your capital, you need to:
- Build a Rainy Day Fund - One of the most effective ways to improve your capital is to build an emergency fund. This means setting aside money in a savings account that you can tap into in case of unexpected expenses or financial setbacks that affect your ability to service a loan. This cushion can help you avoid defaulting on loans or credit payments, which can negatively impact your capital.
- Accumulate Liquid Assets - Another way to improve your capital is to accumulate assets that you can liquidate quickly and easily. This could be assets or other investments you can sell in a pinch. Having these assets on hand lets, you demonstrate to lenders that you have a solid financial foundation and are less likely to default on payments.
Improve Your Collateral
Collateral is when you pledge an asset to a lender as security against a loan. Understanding what (if any) collateral is available, particularly for secured lenders, is essential. Collateral comes in handy when you have bad credit or low capacity but need to borrow.
However, for collateral to be considered, it has to meet a threshold set by a lender. It should have a loan-to-value (LTV) ratio that is desirable to the lender.
How you improve your collateral will depend on your collateral type.
For loans that a lender uses lien, such as Auto loans and mortgages, the lender will usually consider the other Cs of credit. Therefore, you should improve your capital, capacity, and character.
For loans that use external collateral, such as personal loans, mortgage refinance, and logbook loans, you can take three steps to improve your collateral LTV when borrowing. You can:
- Increase the value of your existing collateral by making improvements - If you want to use your house as collateral, you can invest in home improvements to increase its market value before approaching a lender.
- Reduce your debt-to-collateral ratio - Lenders pay attention to the amount of debt you have in relation to your collateral. For instance, if you have an existing debt on your house, the ratio might be high as you will have less equity. Therefore, it may be challenging to secure a higher loan.
- Get a co-signer - If you have trouble improving your collateral, consider getting a co-signer. This person can help you qualify for a higher loan by using their assets as collateral.
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Improve Your Conditions
Unlike the other 5 Cs of Credit, conditions are more comprehensive. Before lending money to you, lenders will consider factors outside your control. For instance, they might consider the economic climate and associated systematic risks it can cause, such as currency or interest rate risks.
To improve your last C of credit when borrowing, you should:
- Have a solid reason for borrowing: Lenders want to know that you're using the funds for a good purpose and have a plan for how you'll pay it back. Whether you're starting a business, paying for education, or making a big purchase, having a well-defined goal for your loan can make lenders more likely to approve your application.
- Invest in Assets You Can Use as Collateral: Consider what assets you could offer as collateral, such as real estate, vehicles, or investment accounts. Having these assets in your investment portfolio allows you to leverage them when you need to take a loan.
- Time your borrowing: The economic climate can greatly impact lending conditions, and lenders consider this when assessing your loan application. When interest rates are low, it may be a good time to borrow, as you may be able to get a lower interest rate. On the other hand, if the economy is experiencing a downturn or significant systematic risk, lenders may be more cautious about lending money. Consider timing your borrowing to take advantage of favourable economic conditions.
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Benefits of High Credit Scores in Kenya
- Lower Interest Rates and Good Terms on Loans: A high credit score can lead to lower interest rates and more favourable loan terms, as lenders are more confident in your ability to repay. This can save you thousands of shillings over the life of a loan.
- Fast Approval for Mortgage and Other Loans: Lenders may hesitate to lend to you if you have a poor credit history due to the risk involved, resulting in a longer and more arduous loan application process.
- Improves Your Chances of Landing a Job: A high credit score can greatly improve your chances of landing a job, particularly in positions requiring financial responsibility. Character is one of the 5 Cs of credit that potential employers may consider when evaluating your creditworthiness. A poor credit score, caused by loan dependency, lack of CRB clearance certificate or salary garnishment due to loans, may signal a lack of financial responsibility and make you less attractive to potential employers.
- Increase your Negotiation Power When Borrowing: With a good credit score, you demonstrate a strong history of managing credit responsibly, which means lenders are more likely to trust you with larger loan amounts and better interest rates. This, in turn, allows you to shop around for the best type of loan, as most lenders will want your business and may be willing to compete for it. So, by focusing on maintaining a high credit score, you can have more options when it comes to borrowing money and better position yourself to get the best loan terms possible.
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Improving credit is an ongoing job that requires consistency and effort. It involves maintaining good financial habits and managing debt responsibly. While the 5 Cs can be a starting point, they are not the only factors a lender will consider. Ensure you talk to your lender to understand their loan requirements.
Additionally, consider taking proactive steps to monitor your credit report regularly. This can help you catch errors or fraudulent activity that could harm your credit.
Finally, remember to use credit and loans properly. Loans are not always the right answer to your financial troubles. Even with a high credit score, you should only take loans when necessary.