I’m here to talk to about the five Cs of credit. These are the underlying decision metrics that lenders use to decide if they want to give you money or not.
What Are the 5 Cs?
The five Cs of credit are character, capacity, capital, collateral, and conditions. This is a fairly ubiquitous framework that lenders use across all types of lending. But today I’m going to talk to you specifically about institutional residential loan mortgages. I have been working in lending for 15 years within the realms of things like auto lending and credit cards. I’ve done small personal retail loans, and now I do commercial business banking.
This is an underrepresented viewpoint on BiggerPockets, and I want to provide a little bit of my experience and knowledge to help you figure out how to better get loans. People ask about lending all the time and I’m actually surprised how big the disconnect is between what people know about banks and how banks actually work. So I wanted to provide a little perspective and I give you some insight. Most of the time people just get in their own way, and I’m great at helping you get out of your way.
While it’s important to know that all banks are different—and they definitely are—they all follow this underlying decision metric. It’s just like how all how restaurants serve food, but P.F. Chang’s is vastly different from
Chick-fil-A. They’re both delicious, but you’re gonna get something different when you walk into each of them.
I want to point out that this is not a comprehensive guide to all underwriting. So I if I leave something out or I skim over something, please don’t message me hate mail telling me that I missed something. I’m aware that I’m not covering all there is to know. I just want to provide some perspective so that you can get paid easier.
So let’s get into it, starting with the first C…
This means who you are as a person. So when you go to the bank try to pretend like you’re a charming and responsible adult. The bank wants to feel very confident in your ability to repay—more so than just if the deal you’re wanting to do makes sense. They want to think you’re competent and able to handle the loan.
Track record matters when it comes to applying for a loan, so sell yourself. I don’t mean that you need to have a track record if this is your first deal, but you should be able to sell your experience and your story in a way that is applicable for the loan in question. To be fair, character used to be a much bigger part of the credit approval process, but these days we have this magical new thing called the FICO credit score. And that plays a big part in your approval.
I know that there are creative ways to get financing outside of institutional banking, so if you have bad credit it’s not the end of the world. However, if you do have bad credit I urge you to work on it so that you do have access to these institutional lenders. The ideal candidate is going to have a good credit score. They’re going to have a decent track record, and they’re going to have a skill set applicable toward the type of loan that they’re trying to get.
This is your ability to repay the loan. It’s not done through the honor system. You need financials. If you’re buying residential mortgage, it’s actually quite simple. It’s going to come down to debt to income (DTI), which is your income minus your debt.
In addition to if you pay the debt service, the bank is most likely going to ask you for a personal financial statement. It’s basically just a balance sheet with your assets minus your liabilities. It’s not a bad idea to go to the bank ahead of time to pick one up. So that way, you’ll already have it filled out when you get to the bank. A personal financial statement is extremely standard, so get familiar with it.
For nongovernment back debt or loans that are not based on your DTI, they’re going to look into two years of your tax returns. They’re also going to base your loan off of your debt service coverage ratio (DSCR). This means that the cash flow of the asset can pay for the loan in question by 1.2 times the debt service. By maximizing your DTI—which I highly recommend—it’ll be much easier for lending. Then all you have to do is increase your income and decrease your debt. Super easy, right?
For my friends who do the burn method, which I love, I cannot stress enough to go to your lender before you buy that house and talk to them about the refinance on the backend. The No. 1 email I get is from people who have bought a house, rehabbed it, put a tenant in it, and now can’t refinance for something they didn’t account for in the first place. Let me just say it one more time: Talk to the lender before you buy.
This is your liquid capital injection and any reserves you have on hand. BiggerPockets members, this is specifically for you and I want you to read closely because I know you’re going to hate hearing it but it’s got to be said.
I know that it’s super in vogue to buy real estate with low and no money down. But I assure you that banks hate you for it. Sorry, Brandon. The bank wants you to have equity for risk mitigation purposes. It makes it easier for them to liquidate when you default. And they want you to have skin in the game.
In addition, you should want equity. I know it’s popular to over-leverage everything right now just to feed your sick little ego so you can go out, buy something, and put it online to brag about. But equity is your risk mitigation; it’s your buffer. It’s not so bad to have 75 percent loan to value (LTV). I work in risk mitigation for a living so maybe I’m biased, but I want you to think about it from a bank’s perspective. The bank thinks in terms of low risk.
You know who’s a high risk? Somebody who has high debt, high leverage, and no cash reserves. One of, if not the biggest reason, that businesses fail is because of under capitalization. Don’t go in too light. Make sure you have liquid capital injection and cash reserves.
This is probably the most important part of this post because most people who read this want to buy residential mortgages, and the collateral is the asset that you fix that loan to. Bankers love collateral because it gives them something to sell after you default. Trust me that liquidations are not fun but they happen.
While it might be annoying to fit into the strict bank parameters, I’m going to be super happy that I only owned that house for 75 percent when the dust settles. Nobody wants to default. You don’t want to default. I don’t want you to default. No banks ever want anybody to default, but it happens.
The fact is the better the collateral, the better the loan. The reason why unsecured, on-demand credit like credit cards are so expensive is because the risk is high. And the reason a 30-year government backed mortgage rates are so low is because the risk is so low. I’ll say it just once more to let it sink in: Better the collateral, better the loan.
This is the loan terms that go along with the deal. For residential fixed rate mortgages, it’s simple: for how long and what’s the rate. If you go to non-government backed loans or an in-house portfolio lender, then the conditions can be infinite because the variables on a commercial loan or infinite.
But, for the most part, if you’re doing FHA, Fannie Mae, or Freddie Mac the terms will be extremely simple because these are standard mortgages. To be honest, conditions isn’t something you’re gonna have to worry about much, so focus more on accomplishing the first four Cs.
Those are the five Cs of credit. To quickly refresh, they are character, capital, capacity, collateral, and conditions. This isn’t a complete list of everything you need to know about bank underwriting, but it is a start.
If you have these in mind when you go to talk to the bank, you should be able to design your strategy a little bit better. I think this is important because most people go to the bank and try to sell them on why they are are a good risk based on what they think is important. And that’s backwards because the bank doesn’t care about any of the things that you think are important.
The bank has a whole slew of other things that they think are important. They make credit decisions based on things you’re probably not even thinking about. But the five Cs may be one of them, so I hope that this gives you a little bit of insight on how banks do business. That way, when you go to the bank you can stop thinking about why you’re such a low risk because of what you think is important. You can start thinking like the bank.
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