What are the 5 C's of credit?
- 02 September, 2022
Buying a home for the first time is a truly exciting and rewarding experience. But it can also be somewhat overwhelming. It’s rather easy to get lost in the weeds of new words and terms, especially when applying for a mortgage loan. To help you better understand the process, it’s important to understand the 5 C’s of credit.
There are five characteristics that lenders may look at when determining your creditworthiness. These include:
- Character
- Capacity
- Capital
- Collateral
- Conditions
Learning about these five factors makes it much easier to prepare for one of your biggest life investments. With the 5 C’s of credit, you can understand how much you need to save for a down payment as well as your credit score and credit history.
Here’s what you need to know.
Character
Character is measured by your credit. Lenders look at your credit score as a key metric to determine your character. Your credit report contains important information about your credit behavior, including accounts, transactions, and payments.
A mortgage lender can review your credit reports to see how many accounts you have, if the accounts are in good standing, and if you pay on time.
Before applying for a home loan, review your credit report and score. Resolve any discrepancies in your report. If your credit score could use a little boost, work to increase it so that you get more favorable lending terms.
Capacity
Capacity is determined by your financial ability to pay your mortgage each month. It’s based on employment, how long you’ve been employed, and income. To determine your capacity and verify your income, lenders will review your most recent federal tax return along with bank statements and pay stubs.
At the end of the day, lenders want proof that you have a stable and consistent income. Your lender will also look at your debt-to-income (DTI) ratio. This helps to determine how much additional debt you can handle (aka how big of a mortgage you can afford).
Capital
Capital is the funds that are left after purchasing a home, along with other assets, investments, and properties. Because a home is likely to be one of the largest purchases you’ll make, lenders want to ensure that you still have liquid assets readily available.
Buyers who have little to no cash left in the bank after buying a home are seen as higher risk. Therefore, it’s important to examine your budget and commit to saving as much money as possible before purchasing a home. This way you have a solid cash reserve, which lenders like to see.
Collateral
Collateral secures the loan. In the case of getting a mortgage, the home is typically the collateral. If you’re unable to repay the loan, the lender is protected because the home is used as collateral.
This is one of the main reasons why lenders typically require a home appraisal and inspection. They want to ensure that the home’s value supports the mortgage.
Conditions
Conditions include all of the big-picture details such as mortgage rates, interest rates, cost of living, and housing demands in your area. Real estate varies from town to town. It’s determined by local conditions that often change daily.
To understand conditions, you must understand supply and demand. In a buyer’s market, you have more leverage to bargain because supply exceeds demand. In a seller’s market, the seller typically calls all of the shots because demand exceeds supply and there are fewer homes available.
Bottom line
Understanding the 5 C’s of credit is a critical part of buying a home. Now that you know them, you can be a more confident homebuyer. When you’re ready to apply for a mortgage loan, Summit Funding Inc. is here to help.
