Basics of Lending- the 4 C’s

After 18 Years as a lender it amazes me that although the mortgage business is ever changing, the basic ground rules stay in place.  Regardless of the program, lenders are always trying to figure out the same information- Can you pay, will you pay, and what happens if you don’t pay?  To simplify matters we’ve come up with a catchy way to explain it, called the 4 C’s of lending.

Character — the borrower’s intent to repay the debt.  The credit report and their credit score show how someone has paid previously and is a good indicator of how they may do so in the future.  If I asked to borrow money from you, you might ask other people who loaned money to me how I paid.  If I didn’t pay them back, it increases the odds I won’t pay you—That’s what a credit report does at a much higher level

Capacity —the borrower’s ability to repay the debt.  This is tied to income and debt.  Lenders use a ratio called the DTI (Debt to Income).  It is based on the gross monthly income before employment taxes are taken out.  Each loan program has a guideline for the DTI and exceptions can be made if it makes sense.  The general rule is a DTI should be no higher than 40%-45% and there are exceptions to this based on the overall strength of the file.  A borrower with a $4000 monthly income should be spending no more than about $1800 on their credit cards, student loans, car payments, mortgage etc.  It does not take into account flexible spending for groceries, utilities, entertainment etc.

Capital—the amount of money available to the borrower for the transaction and to hold in reserve for after the transaction.  Lenders will typically look back 2 months to determine the stability of a borrower’s capital.  We look at bank deposits and ask for explanations when we can’t clearly determine the source.  This is done to ensure that the funds in the borrower’s possession currently are acceptable to satisfy loan guidelines.   For example, a borrower with an average balance of $1000 suddenly has that average increase to $5000 just before the loan application was taken. The new balance is sufficient, but it could be that the borrower has not been able to truly save this money and it comes from a friend or a silent investor.   If the funds are from an unacceptable source, they could be disallowed from the qualification process.

Collateral – the evaluation of the property is.  Even a well-qualified borrower may not be able to get a loan if the value or condition of the home is risky.  In addition to the value, appraisers will scrutinize a property for any health or safety issues.  Big items we are currently seeing that affect this category are –missing parts, like furnaces, toilets, cabinets; exposed wiring; empty swimming pools; and leaking roofs.

Once the 4 “C”s are evaluated, the loan decision is made!