The 5 C’s of Credit

Let’s discuss “change” when it comes to getting a mortgage loan; “The more things change, the more they (honestly) remain the same.”  The current dot the “i” and cross the “t” environment (full documentation) looks a lot like it did in prior years.   Having been in the business for over 20 years, I cut my teeth on full-documentation loans, and did loans that way for years.  Thank goodness we did business that way – it helped me to understand full-documentation loans inside and out, which helps my team and I shine in this day-and-age.  

Ever wondered exactly what is behind an underwriting decision?  Or why some borrowers sail through underwriting, while others struggle? What does it take to get a mortgage?   Even in our world where the automated underwriting system dominates, approvals and denials all have lots to do with the 5 C’s of Credit.   Knowing the 5 C’s of credit will help you understand exactly what a lender is looking for.  I was taught to remember the 5 C’s with the fingers on my left hand.  Here’s a run-down and highlights of each “C”:

1.       Capacity – (The thumb – take your thumb and circle it around.  Of all the fingers on the hand, it has the “capacity” to move around the most.)  

 A borrower must demonstrate the financial “capacity” to handle their debt.  Looking at the borrower’s past income and employment history is a key indicator of the ability to handle future debt.  The following items are taken into consideration when analyzing a borrower’s “capacity”:

Stability – Has employment remained stable for two or more years?  Same or related field?  Has income fluctuated, or has it been consistent?

Income type – What is the nature of the borrower’s income – wages, commission, bonuses, self-employment income, or other?  What is the frequency?  Is it paid on a regular recurring basis, or is it seasonal?  Does any bonus or commission have history?  If from a source other than traditional employment, has there been a history and will it continue at least three years?

Income amount – Is it adequate to cover the proposed new debt?  Any patterns of decreasing or declining income?

Debt – Are the borrower’s debt ratios at an acceptable level?  Is the borrower too leveraged?  Does a payment shock exist?

2.       Capital – (The pointer finger – hold it up like “I’m number one” – think about when you see the winner of the US Open or another sporting event .  When you’re #1 and you have just won something, there’s likely a large payout of cold, hard cash, right?  Capital is all about cash, liquidity, etc.)

The “capital” that the borrower has on hand for down payment, closing costs, and/or reserves will impact the product choice.  In reviewing “capital,” the underwriter would consider the following:

Ownership – Does the borrower have full or limited access to the disclosed capital/liquid assets?  If not, what portion is available for the loan transaction?  Will any amount be gifted (some products have restrictions on gifted funds)?  Will the seller pay any costs (limits exist)?

Access/Liquidity – Are the funds liquid now, or will they be soon?  Is the borrower fully or partially vested?  Are there penalties for withdrawal?  Will the disbursement process be complete prior to the approval/rate lock expiration?

Questions – There are lots of questions to uncover when reviewing “capital,” including:  “Is it enough to meet the requirements for down payment, closing costs, or reserves?” “Whose is it?” “How much is it?” “When can they access it?” and “How much is left over?”

“Capital” and acceptable liquidity includes cash/brokerage accounts/retirement accounts/cash value of life insurance, etc.  These are generally documented with one to two months of statements (all pages).  Any large deposits are required to be sourced and documented.  Non-cash accounts require of liquidation prior to closing.

3.       Character – (The middle finger – imagine it being held up alone – can you see why this finger is tied to “character”?)

 I was taught early in my career that good credit is not a compensating factor – meaning, that if one wanted a loan, it was expected they should at least have a good credit score.  The borrower’s credit report should meet or exceed the credit guidelines for the product/program they have chosen.  Other evaluations of a credit report include:

The FICO score – Middle of three; lower of two.  Is it within an acceptable range for the loan program?

The mortgage payment history and other accounts – Is the number of late payments at or below the lender’s standard?  Is the borrower too leveraged? 

The number and characteristic of each open trade line – Are there enough traditional credit trade lines (non-traditional credit is not allowed these days)?  What is the depth of the report?

Public records/Bankruptcy/Foreclosure/Short sales/Modifications – Are there any?  Were they disclosed?  What is the status?  How will they affect the underwriting decision?

Inquiries – How many have there been in the past 6 months?  Did they result in new debt?

4.       Collateral – (The ring finger – get it?)

A loan is secured using the subject property as collateral.  Since the property is the lender’s protection against default, it must be structurally sound and functional.  When evaluating the collateral, an underwriter considers:

Features and Functionality – Are the features and style of the home consistent with what is available in the area?  Is the home functional, or has it been rendered obsolete by outdated features and capability?

Condition – Is the home structurally sound and visually appealing?  Is the home inhabitable or is it a dangerous contraption?  Is the home complete and appraised “as is,” or will renovations be required?

Property type/Use – Is it residential, commercial, mixed-use, a condominium, or a PUD?  Is it owner occupied, or is it a rental unit?   Is it vacant or occupied?

Subject Neighborhood – Are comparables readily available or far away?  Are there adequate comparables?  Is the property noted as being in a declining market?  Is there an over-supply of properties?  Is the marketing time over six months?   Any of these could trigger an appraisal review.

5.       Conditions – (The pinky finger – since this “C” represents “external” conditions, remember it by the pinky finger, or the most  “external” finger.)

An underwriter looks at the many documents in the loan file to determine if there are any disclosed or undisclosed factors that might adversely affect the borrower or subject property.  A few considerations include:

• Employment at a place that has had a public announcement of shutting down.
• A recently awarded divorce settlement where the borrower has to payout significant proceeds or will have a high alimony/support payment.
• A lawsuit
• An adverse change in the industry that the borrower is employed in
• An adverse change in the area where the subject property is located

MAKING DECISIONS BASED UPON THE 5 C’S – Pretty simple: If there’s an area(s) that is weak, and if it can be compensated by one or more of the other areas that are strong…you likely have yourself a loan.  However, if all areas are marginal, with no compensating factors…you may not.

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