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The 5 Cs of Credit

Wednesday, January 20, 2010 , Posted by Daisy at 5:25 PM


Unless you have all the money in the world, eventually everyone at some point will need to borrow money from the bank. Whether you want to purchase a car, establish a credit history, consolidate debts, or buy a home, there will come a time when you will need to apply for credit.

Today I'm going to explain what all lenders look at when evaluating any credit application. These factors will determine whether you will be approved for any credit be it a $500 credit card or a $500,000 mortgage. Being aware of the factors that affects your application will help put you in a better position the next time you apply for any credit. Theses factors are called the 5 C's of credit.

1. Credit Rating

This factor is based on your credit score, the higher your score the more likely you will be approved. Banks want to know that they'll be getting their money back, and preferably on time as promised. Your past credit history will be a good indication of that. The lower your rating, the higher the risk the bank must take on as a lender to you. This is why it is important to make sure you have good credit in case you ever need to borrow money.

2. Capacity

This measures your ability to pay and is based on your cash flow (income vs expenses). Banks want to make sure you have enough income to meet your existing monthly obligations plus the new loan payments. It is an industry standard to gauge your ability to service your debts by two debt ratios:
  • The GDS (gross debt service) ratio is based on just your housing costs. It shows the proportion of your income that must be used for housing. If you rent and are not looking for a mortgage then your housing costs will include only your monthly rent. If you own a home or are applying for a mortgage, then your housing costs would include your monthly [mortgage payment + heating + property taxes + condo fees + fire insurance]. This total is divided by your gross monthly income to get your GDS ratio or (potential GDS if you're applying for a mortgage).Banks want to see your GDS under 32%
  • The TDS (total debt service) ratio is a wider measure of your ability to pay as it also includes all your other monthly obligations in addition to your housing costs. These include any existing loan payments, your (minimum) monthly credit card payments, and all other monthly payments that you are obligated to pay in addition to housing. Banks want to see your TDS under 40%.
Meeting these two ratios will show that you are fully capable of servicing the added debt you are applying for.

3. Capital

This factor measures your assets and is a component of your net worth. The more assets you have (car, bank accounts, investment accounts, house) the more likely you will be approved. Having assets can only help your application so it serves your best interest to disclose as much as possible them. Even if your debt ratios are above the guidelines set or your credit is not that great, having sufficient assets might be the deciding factor for them to approve the loan.

4. Collateral

This factor serves as insurance for the bank. The more assets you are willing to put up to insure the bank in case of a default, the more likely you will be approved for a loan. A fully insured debt is called a secured debt and because they completely eliminate the risk of the bank they typically offer the best interest rates and easiest approval. Such credits include secured loans, lines of credits, and credit cards. In the case of a mortgage, the house will be used as collateral in the event of a default. The more the down payment or equity you have in the home, the less risky you are as a borrower.

5. Character:

This last factor is the least important (but I have successfully used this many times to convince the banks to approve credit for my clients). It looks at how you are as a person. It looks at your job stability, your education, your profession, your relationship with the bank, and these sorts of things to try to gauge what type of person you are and whether a person of your character is likely to default on a loan.

These 5 Cs of credit are what all adjudicators look at when evaluating every credit application for any lender. Remember they are just lending guidelines and are not written in stone. Having a bad credit rating can still get you approved for a loan if there is collateral or if you have a lot of assets. You can still be approved for a loan if your debt ratios are higher than 32% and 40% if you have excellent credit. You can be approved for a mortgage with no down payment (no collateral) if you have a very high income (capacity). Which factor will be the most important in your credit application will depend on the type of credit you are applying for.

In a future post on credit I will go into more detail on the factor that is generally the most important in any credit application (especially a mortgage) and that is capacity - your ability to service the debt. By looking at your expenses and income, I will show you how to use your TDS and GDS to determine the maximum amount of money the bank will let you borrow when you are looking to purchase a property (or any type of credit for that matter).

Figuring out this amount on your own before speaking to the bank or realtor is the very first thing you should do when planning to buy a home (or even applying for a small loan).

Read more about the first factor here:
Good Credit: How It Works & What They Never Tell You

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