Curriculum Sample

Well-Built Finances eBook excerpt

Lesson 2.5c: The 5Cs of Credit

 

In order to make yourself as favorable to a lender as possible, an easy way to take care of your creditworthiness is by considering the 5 Cs of Credit. Knowing where you stand in each of these five areas will help you to make better financial decisions. Having good credit can absolutely be one of your financial goals! Use the 5 Cs of credit as stepping stones to achieve good credit standing.

 

The first C stands for Character. Your character is measured using your credit score. As we have discussed, your credit score describes your track record on how you use debt and how good you are at repaying your debts. Most lenders will have a minimum credit score requirement for certain types of loans, and a good score gives you access to more favorable loan terms. To monitor and improve your score, it’s important to utilize tools provided by credit bureaus and companies like Credit Karma. Their websites allow you to see your credit report to ensure that all of the information is accurate. This is very important so that when you do go to apply for a loan you aren’t surprised by something on your credit report you didn’t know was there. We’ll talk more about these tools when we talk about fraud and protecting yourself.

 

The second C is for Capacity, as in capacity to repay. This is where a lender will compare how much money you’re bringing in each month (income) against your required monthly payments (expenses). Lenders oftentimes only

take into account expenses that you are required to pay. This includes any monthly obligation that is reported on your credit report, but also alimony, child support, or tax liens. This typically wouldn’t include accounts like your utility bills, or how much you spend on gas and groceries each month. This ratio of required expenses to income is called your Debt-to-Income Ratio (DTI) and is expressed as a percentage:

 

DTI = (Total Expenses / Gross Income) * 100

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A favorable DTI is typically around 35% or less in order to be considered for any new debt from a financial institution. The Consumer Financial Protection Bureau actually recommends a DTI of 43% or lower before taking on a new mortgage to ensure the borrower can afford it.

 

Let’s assume our annual income is $60,000 in the following example:

 

Gross Monthly Income: $5000

Mortgage payment: $1000

Auto loan payment: $600

Insurance payments: $300

Credit card payment: $100

Lawn mower payment: $150 (does not appear on your credit report)

Gas & Groceries: $500

Total Expenses: $2650

Total Expenses needed to calculate DTI: $1700

 

DTI = ($1700 / $5000) * 100 = 34%

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Knowing your DTI before applying for a loan will give you a better idea of your chances of approval. If you are applying for a loan in person, your banker will also be able to tell you what the requirements are for their financial institution. Knowing your DTI also helps you make an informed decision about how much you can and should borrow. We at Well-Built Finances always recommend keeping your DTI at or below 40%, including your mortgage expense.

 

To improve your capacity, we need to either decrease the numerator or increase the denominator in our DTI equation. That means either paying down or refinancing debt, or working hard for raises or promotions, finding new employment, or creating new income opportunities.

 

The third C is Capital. This is any money a borrower uses to make a down payment on a purchase. Oftentimes our good debt loans (like mortgages) will need some sort of down payment from the borrower. Making a down payment on a purchase like this means the borrower has “skin in the game.” In other words, they have a serious interest in whatever they’re buying. Providing a down payment often results in better loan terms for the borrower since they don’t have to borrow as much money as they would have if they didn’t make a down payment.

 

To improve your capital, you need time and discipline—it can take a long time to work up to being able to pay a 20% down payment on a home that costs $200,000 because that’s $40,000! Some people will utilize different types of savings or investment accounts that earn a better return in order to grow their capital faster. Others will decide that it is better to make the purchase now, with a lower down payment, because the value of what they’re buying will appreciate in the time it takes them to save money for a down payment. That same $200,000 house might be worth $300,000 in four years, and all of a sudden 20% needs to be $60,000!

 

The fourth C is Collateral. This means that the amount of money you borrow from the lender is secured by an asset, typically a house or a car. Usually, the collateral is the reason for which you’re borrowing the money, but some institutions will allow you to list some of your more expensive assets as collateral for a personal loan. Remember, these types of loans are called secured loans because there are items of value involved that the lender can take back if you don’t pay the loan. Their right to the asset is called a lien, and your loan terms are usually more favorable than those of an unsecured loan. One of the things lenders will consider with a secured loan is the Loan-to-Value Ratio (LTV). The LTV ratio answers the question: is the collateral worth more or less than the amount of the loan? Loan to Value ratios are calculated by simply dividing the total amount of the loan by the market value of the asset being purchased, expressed as a percentage:

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LTV = (Loan amount / Value of Asset) * 100

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Example: Let’s say you’re wanting to buy a used car with a dealership price of $12,000. You do your research, check an online site like Kelley Blue Book, and discover that the market value of the vehicle is actually $10,500. The dealer won’t go any lower than $12,000 on the price, and you really like the car. You then check with your bank, and they say that as long as your credit score is at least 720, and the vehicle meets their requirements, they will allow an LTV ratio of up to 110%. This means they will lend you up to $11,550 for that vehicle purchase ($10,500 * 1.10 = $11,550). You would be required to pay the remaining $450 to the dealer, and any taxes and fees the dealer will charge.

 

You can improve your collateral options by shopping around and negotiating prices, especially for vehicles and homes. Do not get attached to a house or a vehicle you want to buy until you’ve calculated the effects of the monthly payment on your financial goals or before you’ve discussed the LTV requirements of the lender. It’s much more stressful to try and make a house or car that you love fit into the lender requirements than it is to know how much you can borrow, set limits, and then go shopping.

 

You might also have heard people use the term “upside down” in regards to their car or their house. This means that the market value of the asset is much lower than the amount of money a borrower owes on that property. If they sold the asset, they would still not have enough money to pay off the loan. Two options to overcome this are to save money to make a large payment on the loan or to wait it out. Eventually, they will either have the loan gets paid off, or the market value and amount owed will even out. Good examples of this are boat and RV loans. The value of a new RV or boat immediately drops as you drive it off the dealership lot, but eventually, the value evens out within the used vehicle markets.

 

The fifth C of credit is Conditions. As the borrower, you might have control over some of these conditions like how long you have been employed at your current job, whether you are self-employed, and your job’s industry stability. There are larger conditions you cannot control: current interest rates, how much the bank is willing to lend for a certain type of loan, how you are allowed to use the money you borrow, and the portfolio of loans the lender prefers to keep on their books. Borrowers have the least control over conditions, but to improve your conditions, it’s important to have a legitimate reason that you want to take on debt and that you demonstrate that your income supports your ability to repay the loan. Unfortunately, “I am out of money to pay my monthly bills” does not get you very far with traditional banks and credit unions; banks are still a business and run their operations as such.​