Home Loan Approval is determined by a number of factors pertaining to your financial situation. You might have heard of the 5 C’s, which are Credit scores, Capacity, Collateral, Capital and Conditions. Here are the 5 C’s and how they affect your ability to get a mortgage.
Credit Scores
The Fair Isaac & Company created the FICO score to help lenders determine the level of risk in lending money. Credit card companies and other lending institutions have their own scores. The three largest credit-reporting bureaus (Equifax, Experian, and TransUnion) created the Vantage Score (range 300-850) to compete with the FICO score. Any company that creates a credit scoring system must provide you one free copy of your credit report every twelve months, if you order them. The report includes the your credit score. FICO produces a classic (range 300-850) and NextGen score (range 150-950). All the scores can get confusing and vary depending on what data each company has on file for you.
FICO says their score is based on the consumer’s Payment History, Credit Utilization, Credit History, Types of Credit in Use, and their Applications for New Credit. The component of the score is weighted as follows:
- Payment History – 35% of score :
Are you a responsible borrower? Making payments on time is one of the most important factors? Any payments you make are tracked, such as: credit cards, car payments, mortgages, student loans and other loan types. Public records are also considered, so bankruptcy and real estate short sales affect the score. Being late on a payment and how quickly the payment was made after being late also factor into your score.
- Credit Utilization – 30% of score:
As people gather debt, the FICO score keeps tabs on how much debt you are carrying. The outstanding balance on loans compared to the amount of available credit affects how much a borrower can safely expect to acquire new debt according to their income and assets. By paying off or lowering any outstanding balances you can improve your ability to get a mortgage or a better interest rate on a mortgage.
·Credit History – 15% of score:
Credit history starts the first time someone borrows money. During the time an account is open your record demonstrates the likely hood of future activity. If a person has no credit history then it is recommended you start an account and pay on time, to establish good credit history. Credit history can affect the amount of money that the lender may allow you to borrow for your home loan.
·Types of Credit in Use – 10% of score:
Having different types of credit shows your ability to manage finances. Credit cards, car loans, bills, student loans fall into the 4 main types of credit: revolving, installment, consumer finance and mortgage.
·Applications for new credit – 10% of score:
When you apply for new credit the information is reported to the credit bureaus. It does not matter the credit was granted or denied it is still recorded. Applying for too much credit too fast can damage your credit score.
Capacity
Income – Income is a major factor in determining if your home loan will be approved or not. Your debt-to-income ratio (DTI) is considered. Best practices for lending use 43% DTI. Lenders may ask for proof of income, such as your income tax returns for a year or more to come up with an accurate ratio.
Employment History – Closely related to income is your employment history. Employment history represents financial stability. Moving from one job to the next in short periods of employment brings up a red flag that you may be required to explain to a lender. Short-term employment and gaps in your employment may indicate less capacity for repaying on a mortgage.
Collateral
When applying for secured home loans you must pledge an asset to secure the loan. With a mortgage the collateral is the real estate, with an auto loan it is the vehicle you are financing. Your assets are are considered as potential sources the lender may use to collect the amount owed, if you do not pay them back.
Down Payment – The more of a down payment you can make, the more it will help in getting a loan, because it means the lender is not taking on as much risk. The amount borrowed will be less than the property is worth, which creates equity in the property or collateral. If for some reason the borrower can’t pay and needs to sell the home, the house will sell and the lender will get all of their money back. Down payments can help with debt-to-income ratio, to help lower your interest rate and lower your payments and fees.
Capital
Capital is another name for assets. Your income is one of the main factors for determining your ability to make monthly payments but assets can help to reduce risk. If someone has assets such as savings, other property, investments, cars, or a business, those assets can be sold to insure the mortgage gets paid off.
Conditions
What is the home loan or mortgage going to be used to buy. Is it your first home, investment property, 2nd mortgage, or a revolving equity line of credit? All of these types of loans have different types of risk involved which the lender will consider when deciding your interest rate and approval for your loan.
Planning for home loan approval – There are a lot of things to consider when you apply for a mortgage. Knowing before hand what will affect your chances of getting approved for a mortgage can help ensure you get approval. You can make changes to your financial situation to get a better interest rate. If needed, use the services of a local credit counselor or financial adviser to help you improve the factors that determine home loan approval.