Let me ask you a question…knowing what you know about your situation right now, would you lend money to you? Are you gainfully employed, in control of your personal finances and capable of repaying a loan?
Do you have lots of debt or other responsibilities that could impact your ability to service a mortgage?
The reason I pose these questions, is that this is the type of scrutiny your world will be subjected to when you apply for a home or property investment loan.You see, the banks work to a standard measure of any application that is known in the finance industry as the 4 C’s of credit.
By thoroughly examining your past financial details, employment history and even the number of times you have moved address, lenders can make a more informed decision as to what type of client you will be over the life of your loan and whether your risk profile is palatable according to their internal policies.
If you plan on applying for credit, it is advisable to have a basic understanding of what information will be required and how it is used to assess your standing with the banks.
So let’s take a closer look at what each of the 4 “C’s” represent and how they impact the bank’s final verdict.
As the word suggests, capacity refers to your ability to repay the loan over its lifetime. Your capacity is measured, quite logically, by the amount of income you generate and whether that source of income is reliable.
In other words;
- Do you have a solid employment history, with regular income that is sufficient to cover your living expenses as well as the extra debt you are applying for?
- Do you have other consistent income streams, such as rent or share dividends?
- What is your ability to repay the loan and meet your monthly credit commitments?
In addition to these questions, lenders also look at any other debts you have that might impede your ability to service the additional loan amount you have requested.
When we talk about “character”, we are not referring to whether you happen to be a nice, caring person who volunteers at the local animal shelter. While these traits are admirable in a friend or loved one, they are not at the forefront of the banks’ concerns when it comes to your loan application.
Instead, the banks want to know if you take your financial commitments seriously and will ascertain this by digging into your credit history. Have you maintained good relationships with your debtors by keeping up your end of any past of current credit agreements? Or have you been tardy with repayments?
An exploration of your credit history provides a clear depiction of your character and will answer the questions lenders are most interested in, being;
- Will you repay the loan and meet your monthly obligations in full and on time?
- Have you used credit before and if so, how much and for what purpose?
- Are your financial facilities in order?
- Do you have a history of paying bills on time or are you consistently playing “catch up”?
- Would you lend yourself money and trust you to repay it?
To this day, lenders still request that you provide six months worth of home loan statements in order to assess your character, with this being one of the most reliable ways for them to determine whether you are committed to making your repayments as scheduled.
What are you contributing to the deal? Are you taking this financial commitment seriously by saving a deposit for the property you intend on purchasing, or are you looking for quick, easy money from the banks?[sam id=43 codes=’true’]
This is measured by the Loan to Value Ratio or LVR accepted by various lenders, with the general rule of thumb in Australia being that the applicant is required to contribute at least 10 to 20 per cent of the overall purchase price of a property, with loans of 90 per cent or higher attracting Lender’s Mortgage Insurance (LMI).
Essentially, the banks expect a financial commitment from you, the borrower, in order to cover some of their margins and as a good faith gesture to demonstrate that you are prepared to back yourself.
Think of it as “hurt money”. You must have something that you are prepared to lose before a lender will take a punt on you. Would it hurt you personally if you could no longer uphold your debt agreement?
If your own investment is at stake then, as the banks see it, you will be more likely to come up with those monthly repayments and meet your financial obligations.
What are you worth? Okay, that’s a leading question and we could imply all sorts of values with regard to an individual’s “worth”, but for the sake of this exercise and when it comes to the banks, they are merely concerned with the question of what you own and the dollar value of those assets.
- Do you own other properties and what is their current value?
- Do you have a car and own it outright?
- Do you have shares or other investments?
- What is your bank balance?
- Do you have any other financial avenues to repay the loan if necessary?
Essentially, the banks want to know that if things turn sour and you are no longer able to meet your credit commitments each month, they have some recourse for recovering their debt.
They also want to know that the commitment you are taking on is realistic; can you meet your scheduled repayments and is the loan term agreeable given your current life circumstances?
Is a thirty-year loan realistic for someone in their fifties, who will most likely be retiring in ten to twenty years, for instance? How will they repay that loan on retirement?
A final note
When discussing credit, it’s important to be aware that as of March 2014 lenders will be able to access far more detailed records pertaining to applicants.
Where once credit reports would list only the most significant details about your financial history; past credit applied for, the success of those applications, any defaults or actions taken against you for late payments or broken credit agreements, there is now a lot more information at hand for credit assessors to consider.
Further information they can access about you as of March 2014 includes the amount of credit accounts you have open, the date the accounts were opened/closed and your repayment performance on each account. Assessors will be able to use this evidence to decide whether or not you have too much debt and can afford to take on more.
Why the changes?
These changes are being made so that lenders can get a better idea of your financial situation and therefore make a more informed decision about your capacity to repay the loan.
The changes are designed to reduce the number of people defaulting on loans and therefore lower the cost of credit for everyone. In terms of benefits to the consumer, this should help to reduce interest rates on lending facilities like credit cards in the long term.
The take home message for borrowers is that you need to ensure your financial house is in order and reduce your risk profile in terms of the banks’ perception of you as an applicant.
By doing so, you will not only build your standing with creditors, you will also have the potential to obtain more secure finance with which to build a wealth generating property investment portfolio.