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What are the Five C’s of Credit? Why do they matter?

Have you taken advantage of “buy today and pay tomorrow” offer? Most of you have purchased things using your credit card or took out a loan to buy a car, pay for your college or university. If so, you have a credit history.

There are two national credit bureaus in Canada: Equifax Canada and TransUnion Canada, We are going to assume that most of you are not like my parents who refuse to get a credit card or take out a loan. There is nothing wrong with that and I admire them for that.  They have always been that way, which helped them spend what they can afford instead of spending beyond their means.

Let’s say you desire to own a piece of Toronto real estate when you request for a loan, the lender evaluates the creditworthiness of potential borrower(s) using a system called the five C’s of credit or five cs credit

Using the “five C’s” system, lenders can weigh the following five characteristics; credit, capacity, capital, character, and collateral of the borrowers.  

Based on the conditions of the loan, they can predict what’s the probability of the borrower paying back the loan. Due to advancements in data analytics and technology, the lenders can predict this very accurately. You may not know, but your bank knows how likely you will be able to pay back the loan even before they lend you the money.

The lenders evaluate credit reports, credit score, income statements and relevant documents to access the borrower's financial situation. If you don't have a good credit history, getting your mortgage approved becomes more difficult. There needs to be a sweet spot between having a great credit history vs having too much liability which affects your affordability.  

Let’s break down the Five C’s of credit,

The first C stands for “Credit”, a snapshot of borrowers credit repayment history over a period of time. The borrower's credit history of repaying debt appears in the borrower's credit report. The credit report will detail as to how many loans were borrowed and whether the loan(s) were repaid on time by the borrower. This information is utilized to generate the credit score which lenders utilize to judge a borrower before pulling a detailed credit report.

The lenders like borrowers who have taken a loan versus someone who has never taken a loan, hence having a credit history is very important.  Having a great history of paying back loans on time provide some assurances to the lender. The lender can predict the borrower’s ability to make future payments based on their credit score and report.

The second C stands for “Capacity” or the ability for the borrowers to repay the loan. The lenders seek to understand borrowers income, monthly liabilities, net assets, TDSR (Total debt to income ratio) and GDSR (The gross debt service ratio).  In Canada, for mortgage applications, the lenders would like to see the TDSR ratio to be  <= 40 % and GDSR to be <= 32%. This ratio may differ slightly depending on the type of (A, B, C) lenders.

The third C is “Capital”, lenders consider any capital put toward the investment by the borrower. A large capital by a borrower reduces the risk of default to the lender, it also shows the lender how invested the borrower is in a property. In Canada, there are regulatory requirements such as the borrower needs to have CMHC insurance if the down payment is less than 20%.  In certain cases, downpayment may be a condition put forward by the lender for the mortgage approval, in addition to interest rate and terms of the mortgage.

The fourth C stands for “Character”,  describes the general reliability of the borrower to repay the loan. The type of income (i.e. full time, part time, seasonal), the length of time borrower was employed, what is the borrower’s job security and the lenders may even look at income history and income projection.

The fifth C stand for “Collateral” and it helps a borrower with a secured loan. A Collateral gives some level of guarantee to the lender and if borrower defaults on the loan then the lender can repossess the collateral. A mortgage is secured by homes and typically secured loans have lower interest rates compared to unsecured loans. You may also find that lenders also do an appraisal on your property when they evaluate your mortgage application. Certain lenders do not approve houses that are located in certain zones due to high risk and other factors.   

From home buyers perspective, getting the mortgage approved with the best mortgage rate without impacting affordability is the top priority. The Five C’s of credit [or] five cs credit system is utilized by the lender(s) to help them understand borrower’s ability to make payments for mortgage, what mortgage amount can be approved at what rate, evaluates your creditworthiness, should the mortgage application be approved and much more. There are correlations between the Five C’s of Credit [or] five cs credit, your mortgage getting approved by a lender and getting the best mortgage rates from lenders.

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