Understanding the Five Cs of Credit

Lenders are in business to make money and when a bank lends money it wants to ensure that it will get paid back. To maximize the possibility of being paid back, the bank wants to make sure that there is sufficient assurance that a person can and will pay back a loan.

When you apply for a mortgage, lenders carefully analyse the details of your application before agreeing to proceed with financing. Many lenders determine how likely borrowers will be to repay a loan by making use of five basic components of credit analysis (so-called the Five Cs of Credit). They are described here to help you understand what the lender looks for.

Character
Character is the general impression you make on the potential lender. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan. Your educational background and experience in your field of work will be included. The length of time at your current employment and your current residence will be considered. The longer you have been at both, the higher you will score on the character scale.

Collateral
In a real estate transaction, the lender needs the assurance that, should the borrower be unable to repay the mortgage, the property that is mortgaged is marketable and can be resold. This is why lenders require an appraisal of the value of the property.

Capital
This is your down payment. From a lender’s perspective, the higher the down payment, the more likely it is that you will do all you can to keep up with the mortgage payments. Capital may also reflect your ability and willingness to save money and accumulate assets.

Credit
This is an estimation of how well you meet your credit obligations, as measured by a national credit agency. The credit agency takes information on payments on major credit cards, auto loans, leases, etc. for the last six years and produces a credit score.

Some individuals make the mistake of not paying the minimum monthly obligations on loans and credit cards with the expectation of making a larger payment the following month. These missed payments appear on their credit report branding them as chronic "late-payers", and therefore reducing their credit score.

Capacity
Based on your financial situation, how capable are you of repaying the mortgage? Lenders will review your income level and monthly financial obligations – mortgage payments typically should be no more than 32% of your gross income. In today's market every source of income is scrutinized as whether it is feasible that it will continue.

It is important to understand that these measures can change greatly depending on what the future economy is predicted to do. In a rising economy where property values are increasing, there is a little fear of people losing their jobs. Even if they do, the value of their property has risen so they can sell and get out of trouble. This may not be the case in a declining economy where the risk of job loss is high and property prices are decreasing. In this case the bank will have a more restricted formula to measure your ability to pay back your loan.