Evaluating a Potential Loan: The Borrower

The Borrower: The 3 C’s of Credit

Borrowers are evaluated based on the 3 C’s of Credit: Character, Capacity and Capital. There are some gurus selling courses on how to find private money who say that your credit doesn’t really matter. They claim that all you need is equity in the deal (collateral for the lender) and you will have no trouble finding money. Not to be too indelicate but that brings up another C—Crap. It is true that if you find a screaming deal with lots of equity that you may find lenders but if your credit is poor you will pay very dearly for the funds.

Following is a run down on the 3 C’s of credit and how a private lender may use these criteria to evaluate your project, decide whether they will fund it and, if they will fund, how they may structure your deal.

Character. This is the history of how you have paid your bills and obligations in the past. The banks and hard money lenders will order a credit report detailing all your credit lines, open and closed, and your history of repayment. I probably won’t.

The banks and most hard money lenders will evaluate the borrower’s character with a tool called a FICO score, a credit score. This is a proprietary algorithm created by the Fair, Isaac Company to predict how likely you are to repay your debts. It is studied quite extensively and is a good indicator of a borrower's likelihood to repay a loan. The institutional lenders have specific guidelines. If your project meets the current guidelines (it has been challenging finding bank financing for real estate investors recently) and your FICO score is in the top tier you will most likely be approved for your loan and at the lowest rate available. If your FICO is in the second tier you may be approved but will pay higher rates. Third tier? You may not qualify at all.

So, your FICO score is pretty important, right? Not to me. I have never looked at a FICO score for any of the borrowers I have funded.

If I don’t look at FICO scores you may think that character must not be important to a private lender. Nothing could be further from the truth. Your character is important to me but I evaluate it differently. To me it is trustworthiness that I am looking at. Remember the private lender who spent hours evaluating your deal before you decided to switch to another lender because you found a deal that would save you $100? He does. The investor who shared confidential information that you used to craft a lower purchase offer most certainly remembers that incident and he has told the tale. I sure hope there aren’t stories circulating about how you stiffed your last lender. I may know some of these folks. I go to a lot of meetings. If I don’t know them my partners, the people I lend to, may. We trust each other and share lots of stories. If you have a history of treating partners poorly I am not interested in becoming your next victim.

I want to know if you are honest. When I begin to evaluate your deal I am going to have some questions. Don’t lie to me. I already know the answers to some of those questions. If I don’t, I am going to verify your answers. If you catch me in a good mood, I have heard good buzz about you and your deal looks very interesting, I may give you a second chance to correct any misinformation you provided. You will not get a third chance.

Capacity. This is your ability to repay the loan. The banks and hard money lenders will evaluate this with debt to income ratios, debt coverage ratios or other similar metrics. They will want to know your salary, other income, expenses and how many dependents you have. They will ask for pay stubs, income tax returns and profit-loss statements to verify your answers. They may want to see your balance sheet. Fall below their guidelines and the banks won’t lend. The hard money guys still may. So will I.

Capacity means something a little different to me. I equate capacity with experience. Have you done a lot of deals? Were they similar to the deal you are proposing? Have they turned out well? Have any deals taken unexpected turns? How did you react? What was the result? If you can show me you are following a business model that you have used successfully many times you are going to get my attention. Have a couple deals that took really bad turns but you were able to save with a good Plan B? Tell me about them. I want to get an idea of how involved I have to be in your deal. How often do I have to check in? If I haven’t heard from you for a while do I give you a little breathing room or do I have to start talking to my lawyers? (Yeah, if you don’t talk to me, you may end up talking to a lawyer. That said, I have had several loans go into default and have restructured some deals but I have not yet foreclosed on an investor).

If I think you will be easy to work with and will not need a lot of mentoring or hand holding I am much more likely to fund your deal and on much more favorable terms.

Capital: This is your wealth, your current available assets. Many private lenders will not be very concerned about this. They will be counting on your deal being executed properly to repay the loan. If it is not, the collateral of the underlying real estate will be used to repay the loan. If you have assets and you commit significant funds to a deal it may help you persuade a reluctant lender to work with you and your repayment terms may be better.