Financial Education: Understanding the 5 C’s of Credit
June 28, 2022
Great…first “the 5 factors” that determine my credit score. Now another 5 C’s…how many five-somethings are there?!
Don’t you worry. There aren’t many. Perhaps, I’ll share the “5 Rules of Investing” next. Joking…NOT joking!
First of all, I will say that a seasoned and experienced Mortgage Broker can explain this much better. So, once again, my disclaimer is this: I will review these 5 C’s from an investor/entrepreneur’s perspective.
What are the 5 C’s of Credit?
Many of us have never even heard of this and yet, arguably, this is probably more important than our credit scores.
The 5 C’s are:
- Character
- Capacity
- Capital
- Collateral
- Conditions
These are universally applicable measuring sticks with (especially) institutional lenders worldwide.
As I’ve mentioned previously: when it comes to credit, it’s better to have it and not need it, than to need it and not have it. (And I will keep mentioning this again and again…and again…)
Whenever we are applying for a credit product — personal loan, line of credit, mortgage, business loan or just a new credit card — the lender will want to know you can pay back the money as agreed. Pretty simple in theory, right? Well, on paper, they don’t know you as a person and they cannot tell you apart from me based on an application. They only way to really assess your credit worthiness is through the 5 C’s.
Let’s jump in.
Character
While it’s called “character”, this is referring directly to your credit history — how you’ve managed your debt in the past.
This can be easily achieved usually by pulling your credit score as a quick glance (refer to the previous articles to learn more). We all start developing our track record (aka credit history) the moment we start taking our credit products. Yes, that includes getting a cell phone bill in your name, a cable service and making sure your apartment gets heat and water.
The extenders of these products (aka lenders) may choose to report their observed behaviour on you as a borrower to a (or multiple) credit bureaus.
In essence, character in this case can be tied directly back to your credit report and the 5 factors that determine your credit score. However, let’s not forget that a credit report will contain more information on your track record other than you’re managing your credit card bills, mortgages, car payments and lines of credit. It may also contain information on any foreclosure or bankruptcies that have happened.
A tangent here — as far as I know, if you’re ever thinking about getting a mortgage again, it’s easier if you’ve had a bankruptcy on your file than a foreclosure. Why? Think about it this way: a foreclosure means you did not (or could not) make your mortgage payments (and usually for an extended amount of time) as promised. This is largely seen as a ‘voluntary’ act. As a result, why would another lender give you the same type of loan? Feelings or no feelings, we can all understand the idea of “once bitten twice shy”.
Other the other hand, a bankruptcy could’ve been caused by many other factors that are considered as ‘involuntary’ — a divorce, a failed business, an injury that has negatively impacted your ability to debt service, etc. However, this is not to say it’s better to declare a bankruptcy when you’re in financial hardship than going into foreclosure. Ideally, you want neither on your file (duh!).
Lastly, to develop a strong credit history, always make payments on time and keep your credit utilization at a generally reasonable/acceptable rate (again, see previous articles for clarification).
Capacity
Your capacity refers to your ability to repay loans/debt.
This is determined by evaluating your debt to income ratio. Depending on where you live, you may have heard of terms such as ‘total debt servicing ratio (TDSR)’ or ‘gross debt servicing ratio (GDSR)’.
Generally, a low DSR (debt servicing ratio) signifies less risk for a lender because it’s tell the lender that you:
- have a reasonable amount of debt, and
- are managing your debt well, and
- have the capacity to take on more (on a monthly or annual basis).
Every lender is going to have a DSR. I’ve learned that the DSR can change quite drastically especially when the lender has an appetite to grow their marketshare in certain loan products.
Regardless, here a quick calculations on how DSR is done: add up all your monthly debt payments and dividing that number by your monthly pre-tax (gross) PROVABLE income. Then multiply it by 100(%). And, if you are watching My Daily Dose with Tim, you’ll see how important one of the key performance indicators (KPIs) called the Coverage Ratio (or DSCR — debt service coverage ratio) is when it comes to the lender’s evaluation of a larger building.
Lastly, “when it comes to credit, it’s better to have it and not need it than to need it and not have it”. This doesn’t mean that you get to use your available credit to shop for anything you want. A smart investor leverage credit and debt to build income and wealth.
Capital
Capital tend to include the cash and liquid (or liquidable) assets that you are willing to put towards the loan product you’re applying for. One biggest example is getting a mortgage.
Typically speaking, the larger the downpayment, the better your interest rate and terms will be. That’s because the amount of your downpayment is a direct message to your lender how much ‘skin in the game’ you have. You are serious! Of course, as an investor, one of the main reasons why we love real estate is because we have the ability to leverage up to 80% on investment properties. This means that we can come up with 20% in downpayment against the purchase price of a property. This also means we often will be kickin’ and screamin’ when it needs to be more than 20%.
Lastly, I do not endorse the concept of saving money by any stretch of the means. Tucking money away in savings accounts of any type is possibly the worst way to ‘accumulate’ capital for any investment deals. While you may start to understand/feel this due to the recent inflation numbers, many people in your immediate circles (parents, siblings, best friends, close colleagues, etc.) may be feeling that, too. Everyone wants to work less themselves and their money to work harder for them. This is why I keep repeating what I was taught: when the deal is good, the money will follow. Raising funds to grow and stabilize your portfolio is way smarter and more sustainable (when done properly) than constantly trading hours for dollars to save.
Collateral
Collateral in this case goes beyond the liquid cash (or downpayment) that you may have from your savings and stock portfolio. It includes those plus investments and assets that you are willing to put toward your home. Essentially, a lender will consider the value of your personal (business if applicable) assets of a secondary source — while not ideal — of repayment.
Collateral often times is a significant part of the consideration to a lender. However, the significance of each type of collateral can change depending on the type of loan you are getting. I often think of a lender like an investor. They are giving you the loan largely based on the ‘deal’ you have on the table. They are essentially your partner. As educated investors, we know that “when the deal is good, the money will follow”. This is why, typically speaking, the asset or the deal itself is the first and most significant collateral. Because if the lender does not deem it as a good ‘investment/deal’, you wouldn’t even be considered in the first place.
Lastly, this is why active investors have all heard about ‘qualification based on net worth’ over time. Because the lenders tend to feel a lot safer when they know their money is safe and that there is a lot to ‘go after’ if a high net worth borrower defaults. In the beginning of my career as an investor, the collaterals largely relied on the asset itself (which is great because I chose real estate as my main investment vehicle), my ability to repay on the monthly basis. Later on, it’s become the asset itself and what’s in my overall portfolio. This also sparks the conversation about asset protection. Many make the mistake to put everything in their personal name to boost their net worth right away and choose to continue it that way. Any financially educated person will tell you that is simply…well, stupid. That will be a whole other subject altogether at a later time.
Conditions
These usually refer to the lender’s micro- and macro-research (‘due diligence’) on the condition of the investment, the business, the industry, the economy and (in my opinion), most importantly, the borrower’s intention and plan with the funds borrowed. Most lenders are more inclined to lend money for a specific purpose as opposed to a general loan that can be used for anything by the borrower.
The other external factors like how the economy is, where it’s going, the federal interest rates and budget, etc. are out of any of our control (largely speaking unless you’re the wealthiest person or the most politically influential person on the planet). Every lender has a different perspective and appetite for taking on risks. What we tend to see is then the requirement for a larger ‘skin in the game’ for the borrower.
Lastly, from my personal experience, this is why I remain fond of single family home investing. I understand the path of trading ‘four green houses for one red hotel’. I also understand that everyone needs (and more importantly — WANTS) a roof over their head at the end of the every day regardless of the economic conditions. It’s never about investing for fame or for bigger profit for me. It’s about investing for freedom, for security, for happiness, for choices in life and for the opportunity to make a difference in other people’s lives also. While external conditions may change quickly and drastically (remember: change is the only constant), when we are smart and financially educated enough to think for ourselves, helping others get what they want is ultimately how we create what we want. Or better yet, I’ll end with this Zig Ziglar quote:
Tomy dedicated readers, I thank you for your support and feedback. If this is the first time you’re reading one of my publications, I hope you’ve enjoyed it and learned a thing or two.
If you’re wanting to be a part of a community of real estate investors from around the globe, here is the T.A.L.E.N.T.ed Investors Facebook Group. It’s a place where people come together to share experiences, knowledge, successes and challenges, and money making opportunities!
For those of you who prefer watching videos, here is the YouTube channel where some of my work (very raw) has been shared.
Lastly and definitely not least, Bootcamp! If you prefer the live interaction and delivery to help you build some foundation, our next Bootcamp is on July 23 and July 24. Go ahead and register for a session for either day to help you further your financial education.
(Written at the Anaheim Marriott in Anaheim, CA)
