It should be of no surprise that most individuals (or couples) cannot purchase a home outright. Because of this, many rely on their past credit history, using it as a promise that they are “good for their money” when obtaining a loan.

When someone is looking for a loan banks and financial institutions look at the following items to determine if the buyer is low-risk.

The 5 C’s of Credit

Understanding the 5 C's of Credit1. Character

In regards to character, lenders primarily want to see your credit history. Notably, the frequency of debt and how quickly you repay debts. Was it within the allotted time limit? Were any payments missed?

People who make credit payments on time are much more likely to receive a loan.

It’s your responsibility to stay on top of scheduled payments. Check your credit history to see if there is a repeated history of you paying your bills on time. If this isn’t the case, start practicing great habits to improve your credit history.

2. Capacity

Capacity is another important aspect of credit. It means the likelihood of you paying the loan on time. Assessing the capacity of a potential borrower entails looking at their debt-to-income (DTI) ratio.

This ratio is generated by totaling the borrower’s monthly income to their recurring debts, allowing the lender to see how likely it is for the borrower to make their payments on time.

For example, borrowers are generally required to have a DTI ratio of 43% or lower to qualify for a mortgage loan. Why? Mortgage lenders have to make sure borrowers have the bandwidth to make their monthly payments even amid recurring debts.

3. Capital

While having good credit goes a long way, lenders expect potential borrowers to have some capital.

Typically, having enough sufficient capital means possessing at least a 20% down payment.

The presence of high capital prevents the chance of default. Having some capital ready for a down payment makes you a safer investment for financial institutions.

4. Collateral

Lenders can be pessimists — and they should be. It’s their money being used upfront.

Having collateral that meets or exceeds the state of the loan gives the lender assurance and peace of mind. Either way, they’ll get their money whether you make your payments on time or default on the loan.

So, what is used for collateral? More often than not, it’s the item the buyer took a loan against. For example, in a mortgage loan, the home is collateral. In an auto loan, the vehicle is collateral.

5. Conditions

Finally, the conditions of a loan (interest, principal amount, etc.) influence the lender’s decision to approve a borrower.

Once set, the conditions of a loan cannot be changed. So, expect a fair amount of negotiations and back and forth. Both the lender and borrower need to be comfortable with the loan conditions before signing.

Excellent credit history goes a long way when looking to acquire a loan for homeownership. And the first step of great credit is understanding credit and the 5 C’s of credit.

Have questions? Contact Equity First Funding today!