Lenders assess five ‘Cs’ of credit
In his book Paper Promises: Money, Debt and the New World Order, Philip Coggan points out that the word credit derives from the Latin word credere, which means to believe.
In other words, when we borrow money we believe that we will have the financial capacity in the future to pay back the loan in full.
In turn, the credit union or bank that lends you the money believes that you will pay back the loan using future income.
The basis for lenders’ decisions on whether a person will pay back the loan is referred to as the five Cs of credit: capacity, collateral, character, capital and credit.
The most important component of a good lending decision from both the lender’s and borrower’s point of view is whether the potential debtor can repay the loan.
Your ability to repay a loan is based on the proportion of your income that is taken up by debt payments — for example loan and lease payments — rent if you do not own a home, and other bills, such as heat and hydro, condo fees and property taxes.
Usually if the total of these payments is greater than 40 per cent, your request for new credit will be declined.
This is your total debt service ratio and it should be as important to you as it is to the lender.
A more stringent ratio used by lenders is your gross debt service ratio, which is the sum of all your debt repayments, excluding such items as heat and hydro, property taxes and condo fees. A gross debt service ratio of greater than 32 per cent will more than likely result in a new loan being declined.
The important take away for those seeking to finance a purchase is that the difference between these two ratios is eight per cent. In other words, if more than eight per cent of your income is currently taken up with unsecured loans, lines of credit or credit card payments, you are potentially putting your hopes for future borrowing in jeopardy.
Just as important is collateral. Collateral is essentially a secondary form of repayment for the lender in the event that you do not repay the mortgage. It is also a means of reducing the total cost of borrowing.
Security, in particular real estate and conservative (low-risk) investments, are preferred forms of collateral.
Having a steady recurring income and collateral will help you obtain a loan or mortgage. However, character is just as important as your financial ability to repay a debt.
In “banker speak,” character is the ability to demonstrate your willingness to repay a debt. It is generally measured using credit history (more on this later) and your use of overdrafts and chequing accounts. Cheques returned as insufficient funds, and an over-dependence on overdrafts, can potentially send a signal to lenders of your potential inability to repay debts in a timely manner.
Remember, credit is the belief that you will make debt payments on time.
Capital is essentially your net worth: total assets less total liabilities. Many people just don’t believe me when I explain to them that financial institutions want you to repay loans and increase your net worth.
Why? Banks and credit unions need both savers and borrowers.
Savers have excess cash which they deposit into savings accounts and GICs which are the basis for lenders’ ability to lend. So banks, credit unions and other financial institutions want long-term stable customers that they can both lend to and borrow from. A growing trend in the net worth of their customers will eventually feed an expansion of credit.
Aside from capacity, credit is perhaps the next most important factor in being approved for a mortgage or any other credit facility.
Credit is simply measured by your credit history as reported by Equifax or Transunion. It is a number created by complex statistics but it can have a big impact on both your ability to be approved for financing and its total cost.
The higher your credit score, the higher the probability you will be approved for a loan and the lower the total cost of borrowing.
So the next time that you are thinking of borrowing, keep in mind the five Cs of credit. After all, you want your banker to believe in you and your ability to use credit wisely.
Remember, you are in control of your financial destiny.
Easy Money is written by Patrick O’Meara, an instructor at Red Deer College’s Donald School of Business. He can be contacted at Patrick.O’Meara@rdc.ab.ca.