The Five Cs of Credit

Whether you are interested in purchasing a property as an investment or to occupy it, it is important to be able to be prepared and competitive throughout the transaction process. As sellers compete with other homeowners through the listing of their home in order to attract the right buyer, buyers must remain competitive on two fronts: with other buyers and in negotiations with the seller. Understanding your budget and the size of the mortgage you qualify for, is a significant part of the buying process. Don’t wait until you have submitted an offer on a home before going through the pre-approval process. You may come across literature that includes the mortgage pre-approval process after you make an offer on a home; however, speaking to a lender direct or through a Mortgage Broker about a mortgage early in the buying process, provides benefits like locking in your rate, in most cases for up to 4 months, in addition a proper pre-approval will be fully underwritten at the time of application so there are no post offer surprises, this increases your purchasing power by eliminating the financial stress during the process of negotiating your offer.

During the mortgage pre-approval process, a lender will evaluate a potential borrower’s profile, which encompasses five factors. They are often referred to as the Five Cs of Credit. The five factors include:

Character

Since past behavior is an indicator of future tendencies, the foremost measurement factor, is your credit history. A credit report is a detailed list of your credit history, consisting of information provided by lenders that have extended credit to you and how well you have managed credit and made payments. In other words, it is a borrower’s trustworthiness to repay a loan. The overall credit score, otherwise known as a beacon score, ranges between 300-850. The higher the score, the lower the perceived risk. A credit score above 700 is generally considered good. These reports also contain information on collection accounts, judgments, liens and bankruptcies, and they retain most information for seven years. Higher credit scores (greater than 700) will allow some lenders to use higher qualifying ratios for your mortgage versus your income, again increasing your purchasing power.

Capacity

Can you afford your mortgage payments along with other living and credit expenses? Lenders need to determine whether you can comfortably afford your payments. Your income and employment history are good indicators of your ability to repay outstanding debt. Income amount, stability, and type of income may all be considered. The ratio of your current and any new debt as compared to your before-tax income is measured for your budget. The most predominate measure of income to debt analysis is your Gross Debt Service ratio and your Total Debt Service ratio which may vary by lender and your credit score however the range is in the 32% to 40% category up to 39% to 44% and with some alternate lenders going as high at 48%, a pre-approval will confirm your ratios and what you can qualify for.

Capital

While your household income is expected to be the primary source of repayment, capital represents the savings, investments, and other assets that can help repay the loan. This can be helpful if you lose your job or experience other setbacks. Loan to value is a measurement used to determine the amount of capital required as down payment, in addition to rate and terms of the mortgage. A large contribution by the borrower decreases the chance of default. If the lender detects weakness in any of the other Cs, they may ask for more money as a down payment to secure the loan.

Collateral

Loans, lines of credit, or credit cards you apply for may be secured or unsecured. With a secured product, such as an auto or home equity loan, you pledge something you own as collateral. The value of your collateral will be evaluated, and any existing debt secured by that collateral will be subtracted from the value. The remaining equity will play a factor in the lending decision. The lender will ask themselves “how marketable is this property?” which gives the lender the assurance that if the borrower defaults on the loan, the lender can seize the collateral to repay the debt and mitigate any losses the lender may incur.

Conditions

Conditions are twofold. Lenders will consider broader economic factors, such as the state of the economy, interest rates, trends in the real estate industry, current and pending legislation relevant to real estate in concert with more narrow factors, such as how you plan to use the money. Most lender conditions are part of their approval to you in writing as they do not generally complete the due diligence on your support documentation until you have accepted their commitment and have a conditional or firm offer on the house you are buying. If you are buying conditional to financing then the pre-approval process becomes even more important as you want all of your support documents reviewed and accepted by the lender before you waive you financing clause.

Getting this done at the onset of the purchasing process ensures you are moving along the curve to your closing in a streamlined and organized fashion allowing you to focus only on making sure the house of your dreams is ready for you.

The Five Cs of Credit is a common term in banking. Banks will lend when there is a low risk of default and a high probability the loan will be paid as agreed. As the risk lowers, often the interest rate and borrowing costs will be reduced, making the loan more attractive for the borrower and more competitive to the lender. Understanding what a lender is looking for allows you to set yourself up to put your best foot forward.