Homebuyers who wish to finance their purchase with a mortgage loan must apply through a lender. Lenders want to ensure they loan money to reliable borrowers who pay back their amount in full and evaluate each applicant’s risk level through the underwriting process. During the underwriting process, lenders look at a borrower’s current financial standing and history.
Even though each lender has their underwriting system, they all consider the 5 Cs of Credit: character, capacity, capital, collateral, and conditions. Continue reading to learn more about each component and how it can affect the mortgage application process.
Why Are the 5 Cs of Credit Important?
Those who wish to apply for a new credit card, take out a loan, or secure a mortgage must work with a lender to achieve their desired funding. That lender wants to ensure that they provide financing to a reliable borrower who will make their minimum payments promptly.
Lenders risk losing their funds when they provide them to borrowers. A potential homebuyer who acquires a loan and then fails to make those monthly payments can lose their home in a foreclosure. During a foreclosure, the bank undergoes a lengthy legal process where they acquire the house and then try to resell it to recoup the money they lost with the outstanding debt on the mortgage.
Foreclosure is costly for lenders in both time and money, so they take precautions to try and avoid any loss. Therefore, they’ll fully evaluate the potential borrower and comb through their financial history to determine the borrower’s risk of not repaying the loan.
The first “C” that lenders will take into consideration is a homebuyer’s character. This does not consider the applicant’s characteristics but evaluates their credit-related behavior.
Lenders are likelier to lend to borrowers with a solid history of repaying lenders in full and on time. Borrowers with reputable repayment histories may also have higher credit scores, proving their trustworthiness to lenders.
If borrowers worry about their credit score, they should consider delaying their homebuying process. During this time, they can improve their credit score by paying their bills on time and paying off a decent amount of debt. While borrowers may secure a mortgage with a credit score of 580, they should work to increase it as much as possible to help secure a lower interest rate.
Lenders consider a borrower’s capacity, which determines how likely someone is to repay their debt. Several variables impact a borrower’s capacity, the most important being their debt-to-income ratio (DTI).
A DTI looks at someone’s current outstanding debt and income, then calculates how much of their income must go toward their current debt and the proposed debt they’ll take on with the new loan. Borrowers should aim for a DTI below 36%, but some lenders may work with ratios up to 43%.
The amount of capital, or money, that a borrower currently has available will be an important component of applying for a mortgage. Lenders assume that borrowers with a decent amount of available cash (or cash equivalents, such as money market accounts) will have an easier time making future payments. A higher amount of capital also decreases the amount of money the lender provides through the loan, reducing their overall risk. Homebuyers should strive to pay 20% for their down payment to avoid paying for private mortgage insurance (PMI) and decrease their monthly mortgage payments.
In most cases, lenders ask themselves, “what will happen if the borrower stops paying us back?” Lenders are more likely to provide funds to someone with additional assets that they can claim as collateral. A loan backed with collateral is a secured loan.
Borrowers with tangible forms of collateral, like a home or a car, appear more favorable to lenders as they can physically seize that asset in the event of non-repayment. Collateral allows borrowers to secure a higher-priced item, or mortgage, due to the increased security they provide the lender.
Lenders also consider the overall conditions, or general circumstances, related to the loan. Conditions can relate to a borrower’s job security, current market conditions, and interest rates. Lenders may be more likely to issue a loan to a borrower during a healthy and stable market, where they feel more confident that the applicant can maintain a steady job.
Borrowers should consider the 5 Cs of credit before securing a mortgage. They’ll have time to evaluate their credit weaknesses and pay down outstanding debts, pinpoint what they can use as collateral, and decrease their debt-to-income ratio. The stronger a borrower’s credit profile, the more likely they will secure a mortgage with a low-interest rate.