A system that many lenders employ to evaluate creditworthiness, the 5 C’s of Credit are an informal but widely used methodology in the approval process for mortgage loans. They are: Character, Capacity, Collateral, Capital, and Conditions. Let’s look at why each C plays an important role in buying a home.
- Character. It’s not just about numbers when a lender is evaluating an application for a mortgage loan. Beyond credit history and past payments on other debts (which are important), lenders often like to gauge the overall creditworthiness of an applicant by looking at things like references, work experience, and one’s reputation with other lenders. These supplemental factors aren’t as critical as credit history, but they can play a significant role.
- Capacity. This C asks if the borrower has the capacity to repay their mortgage loan. And that ability is largely based on the applicant’s cash flow, determined by their debt-to-income (DTI) ratio. If you’re applying for a mortgage loan, you should know your DTI, which is your monthly debt payments divided by your monthly gross income. Different loan programs have different DTI requirements. An FHA loan, for example, usually requires a DTI of 43% or lower, while USDA loans often have maximum DTI limits of 41%. A few mortgage products, such as Investor Cash Flow loans, don’t take DTI into consideration.
- Collateral. This is where a lender will look at any valuable assets that the potential borrower has; a borrower with these assets is a lower risk for the lender. This collateral could be real estate, cars, investments, money in bank accounts, inventory or equipment for a business, and more. The more collateral a potential borrower has, the better terms they may be able to get for their mortgage loan.
- Capital. With mortgage loans for homes, this C is primarily about how much money a borrower is putting down. Generally, the bigger the down payment, the more confidence a lender will have in a borrower. While VA loans require no money down, and other federally backed programs such as FHA loans have low down payment requirements. No matter the loan, a higher down payment raises the chances of loan approval.
- Conditions. Beyond the borrower’s personal financial situation, lenders consider a variety of market conditions. This could include the recent trajectory of interest rates, the current housing supply, employment numbers, inflation, and the overall state of the economy. These outside factors provide context to the other 4 C’s.
While potential borrowers can’t control every aspect of every C on the list, there’s much they can do to improve individual areas. If you have questions about your current scenario, contact us to talk about the mortgage loan that’s right for you.
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