The 5 C’s of Credit: What They Are and How They Affect Your Mortgage Loan

red blocks on brown wooden table
Photo by Tierra Mallorca

When a person is looking to do a loan, the creditor or lender will review 5 C’s to determine a person’s willingness or ability to repay their loan. It will also help the lender determine the risk involved in lending the person money. This is a way a lender will rate the people applying for credit.

  • Character: This is in reference to a person’s credit history or reputation when it comes to paying back debts and involves information from the person’s credit report. The lender looks at your FICO score(s), the amount of money borrowed in the past and present, if the payments were made on time, if there are any charge-offs or collection accounts, and any alerts appearing on the person’s credit report. The credit FICO scores will also determine the kind of interest rate the person will receive as the lower the score, the higher the risk, the higher the rate.

  • Capacity: This is a determination of the person’s overall ability to repay their debts based on the person’s debt-to-income ratios and the personal housing ratio if they are applying for a mortgage. The debt-to-income ratio is calculated by adding up your monthly payments listed on your credit report plus the current payment for the loan you are applying and divide that by your gross monthly income. You do not have to include monthly household bills such as electric bill, cable bill, groceries, etc. The Gross Monthly Income is income prior to any taxes are taken from the income.  Lenders would like to see this number at 35% or lower and mortgage loans may allow this number to be higher based on other factors.

  • Capital: This is the amount of money a person has for the down payment or available in case of emergencies. The amount of a person’s down payment can affect the loan terms that could put you in a better financial position. Lenders see down payment as an investment into the loan and sees this as a positive factor when reviewing the entire loan. Larger down payments make the loan a little less risky and may put the lender in a better position. Ex. If the person is purchasing a car or home and putting 30-50% down payment, the lender has less risk of the person defaulting on their loan. A person would not want to lose all that money and will do what is necessary to avoid repossession or foreclosure on the loan.

  • Collateral: This is the item the person is using as collateral for the loan. Examples: Car for an auto loan, home for a mortgage loan, etc. In most cases, this is the item the borrower is using to borrower the money to purchase. The better the collateral involved, the less risky the loan. If you are borrowing money for a home, the home will be appraised to show what the value is of the collateral and the loan-to-value ratio is considered for approval. This is when the down payment will determine the loan-to-value ratio. Example: Home is selling for $300,000 and the person is putting down $69,000 will equal a 77% loan-to-value ratio. This puts a lender in a good collateral position as the home value will appreciate and if they must foreclose, they will be able to sell to get their loan amount paid off easier.

  • Conditions: This includes how you will use the credit, loan purpose, market conditions, and other factors that will determine ability to pay back the loan or how it will affect the personal financial health. Will you use the funds to get into a healthier financial situation or just accumulate additional debt that you will not be able to pay back.

Many lenders base their credit decisions on the 5 C’s but will look at other items as well. Most everything is covered by the 5 C’s but the lender may even consider the relationship with the person.

Credit Unions and banks will look at your accounts the person may have with them and see if they have direct deposit, other loans, and high balances in the account. The lender may take a little higher risk if the person is loyal and shows they make their payments on time.

I hope this has helped understand how lenders make credit decisions and how you can review your own credit worthiness before applying for credit.

Leave a Reply

Your email address will not be published. Required fields are marked *