Lenders have a range of criteria they use to evaluate a borrower and their ability to repay a loan. Among those criteria are the 5 C’s of credit which help a lender to build a financial profile on each borrower. By learning about the 5 C’s of credit, potential borrowers are able to provide a more complete and meaningful loan application to present to the loan officer and underwriter. Read on to learn more details about the 5 C’s of credit and important information to know during the home buying process.
What are the 5 C’s of Credit and why are they Important?
* Character: the lender wants to have a high-level view on who you are as a borrower. To evaluate a borrowers character might involve taking a look at a borrowers work history, a borrower’s residence history, and most important is a borrowers credit history. Does the borrower have a pattern of stability in their employment and their home life and has that borrower shown an ability to pay their bills on time using a mix of different types of credit. Lenders will use information from a borrower’s credit report to see what types of credit have been extended to a borrower, how much total credit is outstanding and the payment history on this credit.
* Capacity: lenders need to determine whether a borrower can comfortably handle their monthly credit obligations. To do this a lender will evaluate a borrowers past income and employment history which are both good indicators of the borrower’s ability to repay outstanding debt. A borrower’s income amount, length of time on the job, and the type of income will all be considered on a borrower’s loan application. Lenders will evaluate a borrower’s debt-to-income ratio, that is the ratio of how much you owe to how much you earn. The lower your debt-to-income ratio, the more confident a lender is in your ability to repay your creditors.
* Collateral: (when applying for secured loans): any loans, lines of credit, or credit cards that consumers may apply for will be secured or unsecured. With a secured loan, the borrower is pledging the item that they are buying as security for the loan. The value of that collateral will be appraised or evaluated, and the lender needs to know that the collateral you are borrowing against has a high enough value to support the loan.
* Capital: while a borrower’s household income is expected to be the primary source of repayment funds, capital represents a borrowers net worth, including savings, investments, and other assets that can help repay the loan. This can be helpful if a borrower loses their job or experiences other setbacks.
* Conditions: lenders consider a number of outside circumstances that may affect a borrower’s financial situation and ability to repay. For example, what is happening with the local economy and how might that be affecting the business of the borrower’s employer. Have there been any community or personal conditions that the borrower has had to overcome in managing their finances. Demonstrating an ability to continue to manage one’s financial obligations even if facing personal adversity would show the lender this borrower is a good credit risk.
Knowing that the 5 C’s of credit are a part of the lenders evaluation process on a loan application can give a borrower an edge in getting one’s financial profile in order before applying for a loan. Starting early in shaping your financial profile and putting your financial house in order is important to qualifying to buy a home.
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