People in the lending business often refer to a concept called the “Five Cs.” These are the five basic factors that lenders consider when considering a loan application:
- Character
- Capacity
- Capital
- Conditions
- Collateral
Over the years, lenders have learned through hard experience that they can ignore the Five Cs at their peril. Nevertheless, some lenders are stricter than others in applying them – with bank mortgage lenders being among the strictest of all.
That can be an obstacle when you’re trying to finance a property: Traditional bank approaches to underwriting often require borrowers to “check the box” across all five of these dimensions – and they use very strict criteria to assess each one. Banks do this because their business model relies on quickly selling their mortgages to Fannie Mae or Freddie Mac, in what we call the “qualifying market.” And Fannie and Freddie won’t buy their mortgages unless they conform to strict underwriting standards.
Many borrowers, when assessed through the lens of the five Cs of credit, don’t fit the traditional bank lender’s criteria. Lots of great borrowers have challenges in one or more of these five dimensions which puts them outside their banks’ lending criteria.
If you don’t meet the banks’ lending criteria across all five of these dimensions, chances are you won’t get approved for traditional bank financing.
Fortunately, borrowers with less-than-ideal loan applications aren’t limited to traditional bank lenders. In fact, there are hundreds of alternative non-bank lenders who aren’t tied down by Fannie and Freddie rules or stringent bank regulations.
These lenders, focusing on the five Cs of credit, are not as reliant on Fannie Mae and Freddie Mac guidelines. They usually plan to hold these loans in-house, and service them themselves. We call them “portfolio lenders.” That is, they are lending for their own portfolio, rather than selling their mortgages to one of the quasi-government mortgage giants.
There’s life beyond Fannie and Freddie.
Credit score and the five Cs of credit: A broader perspective
In real estate lending, income isn’t the only thing lenders look at. In fact, income by itself is a very minor factor. This can be frustrating for some borrowers, who assume that just because they can show a high income, they are competitive for a very large loan.
Similarly, while personal credit scores can be important, they are by far not the only criteria that lenders consider when setting interest rates. This can also be frustrating for some borrowers who assume that because they have a FICO score, they’ll get the best interest rate.
But lenders don’t just look at your hard FICO score. They look at a wide range of both hard and soft factors, all of which contribute to their assessment of your overall risk profile, and therefore the interest rate and terms available on the loan.
So there’s a lot more to calculating your loan amount than just your income, and a lot more to calculating your interest rate than your credit score.
To understand why, let’s look at each of the Five Cs in more detail.
Non-bank lenders: Flexibility with the five Cs of credit
Because these lenders aren’t beholden to bureaucrats at Fannie Mae and Freddie Mac, they are free to set their own lending criteria. They have more freedom to be flexible regarding the underwriting hoops the banks have to jump through, and look at the totality of the borrower’s situation, the property, and overall market conditions.
These alternative lenders and portfolio lenders in the non-QM market can see past things like credit blemishes, high debt-to-income ratios, residency and citizenship issues, recent bankruptcies or defaults, self-employment, or non-standard income sources.
If the investment is sound, and the collateral supports the loan and provides the lender adequate downside protection, chances are excellent that you can get approved for financing – even if you’ve already been turned down by bank lenders.
This is true for residential and commercial financing alike.
Let’s take a closer look at each of these “Five C’s,” in turn, and how non-bank lenders can help non-standard borrowers in a variety of situations.
Character
In generations past, hometown bankers could issue a loan because they knew you, and they knew your family. These bankers knew your parents were good for their loan when they bought their house, and they knew you would probably be good for it, too.
Banking has changed a lot since then. Today, bankers don’t have that personal knowledge to go on. But character is still important, and past history is still a useful indicator of how reliable most people will be at paying off new debts.
Today, bank lenders primarily use credit bureau reports, such as your FICO score, as a proxy for their character assessment.
However, credit scores are imperfect measures of creditworthiness. Many people go through temporary difficulties through no fault of their own. There’s nothing wrong with their character. But their credit report shows some dings.
Fortunately, many lenders look at factors beyond your credit score to assess your character. Depending on the lender, they may also consider your interactions with other lenders, your track record of successful completion of construction or rehab projects (if you’re applying for a construction loan), your work experience, and your standing in your industry and community.
Banks typically impose a minimum credit score. Even if they didn’t, Fannie and Freddie still do. They even require that borrowers have not gone through bankruptcy for the past 2 to 4 years, depending on the circumstances.
If you’ve had a recent bankruptcy, most traditional bank lenders won’t touch your application. If you have current delinquencies or judgments against you, a garnishment, or tax liens, most bank lenders won’t work with you.
But lots of non-bank, non-QM lenders will. They don’t need to worry about what Fannie and Freddie want. They aren’t going to sell the loan to Fannie Mae or Freddie Mac. If the collateral and the assets are there to support the loan, your credit score can be a non-issue to them.
If you’re in this boat, contact us at DAK Mortgage today.
Capacity
“Capacity” refers to the borrower’s financial ability to repay. Lenders don’t want to foreclose. Largely, capacity is a function of cash flow – and lenders look not just at income, but at outflows, too.
To assess capacity, traditional bank lenders look at verifiable income and compare it to your existing monthly debt obligations. They then calculate your debt-to-income ratio, or DTI. In the residential market, the maximum DTI ordinarily allowed for a conventional mortgage is around 36%, though those with good credit can get conventional financing up to a DTI of about 45%. That is, monthly debt obligations cannot exceed 36% or 45% of your reliable, recurring, verifiable income.
But lots of perfectly capable borrowers fall outside these DTI limits. For example, some borrowers have lots of income, but it’s difficult to verify, or from a non-standard source that most bank lenders don’t recognize. Or the income is verifiable – but debt service is very high, leaving very little at the end of the month to cover debt obligations out of personal income.
But some non-bank, alternative lenders can lend despite a high DTI. And in some situations, such as asset-based, “hard money” lending, lenders can ignore it altogether.
Here are some common ways to overcome a high DTI:
- Put up more collateral. With enough collateral, lenders know they have sufficient protection even if you can’t make the payments. If you fail to repay, the lender can foreclose, take possession of the property, and sell it themselves. If the collateral is sufficient, there are many alternative lenders who are willing to lend on that basis alone. This is routine among “hard money” lenders, who often lend solely based on the property or other collateral, without regard to personal credit, income verification, debt-to-income, or tax returns.
- Make a higher down payment. Lenders want to know that you as the borrower have “skin in the game.” That is, they are more comfortable lending if they know that you yourself will take a financial hit in the event of a default. This is why lenders typically set caps on the amount they are willing to lend on a property. By requiring a significant down payment, they know you’re committed to the success of the project, too. When you have a higher down payment, the loan amount is smaller, and you are effectively putting up more collateral in relation to the size of the loan.
Here’s an example of how one DAK Mortgage client was able to close on his dream oceanfront penthouse condo, despite having a high debt-to-income ratio.
A higher down payment doesn’t mean you have more capacity. But it does put you in a better position when it comes to capital, the next of the Five Cs of financing:
Capital
Are you sufficiently capitalized? If your income takes a hit, or something happens with the property, do you have enough assets and sufficient liquidity to keep making payments until the storm passes?
Lenders often look at how well capitalized you are. Do you have sufficient reserves to handle a period of unemployment or a disruption in your business operations?
For example, lenders typically require reserves equivalent to at least 3 to 6 months of PITIA (payments, interest, taxes, insurance premiums, and association dues). On larger loans, that reserve requirement can go as high as 18 months.
Reserve requirements are often higher for first-time homebuyers, who may be required to show 6 months’ worth of reserves, compared to 3 months of reserves for non-first-time homebuyers.
Access to capital may help borrowers overcome shortcomings in other areas. For example, you could have little or no verifiable income, but significant assets in savings, a brokerage account, or even in crypto. These assets are available for you to sell to make your mortgage payment, under an asset depletion program.
Conditions
Lenders always take economic conditions into account. If they sense an economic downturn, they pull back lending, especially in more economically sensitive subsectors. If they forecast an increase in inflation, they will increase their required interest rates to compensate for that. If a given project, industry, or geographic location is experiencing difficulties, they will cut back on lending and increase interest rates, required down payments, collateral, or tighten up on underwriting to account for that risk.
The COVID Pandemic was an excellent example of that phenomenon. In the Spring of 2020, when the world was seemingly getting turned upside down by the Coronavirus, many lenders restricted their lending or suspended their loan programs altogether.
Fortunately, that turned out to be a temporary measure, and the market quickly recovered. But for a short time, it was much more difficult to find a loan.
Borrowers who may be affected by negative or worsening economic conditions in the future should expect to pay a slightly higher interest rate, more stringent underwriting, or shorter loan terms.
Collateral
Collateral is possibly the most important of the five Cs. If the collateral is strong and sufficient to make the lender whole even if the borrower doesn’t make a single payment, most lenders will be eager to lend on it.
If there’s enough collateral, some lenders – particularly hard money lenders – are willing to overlook problems in all the other “C’s”. We even have lenders willing to lend on non-warrantable condos – properties that are ineligible for traditional conforming loans.
Interest rates may be a little higher: Foreclosure is lengthy and expensive, and interest rates must compensate the lender for the risk of those costs and delays in the event of foreclosure.
But for challenged borrowers, when all else fails, structuring a deal with enough collateral, along with a clear title or title insurance, can overcome almost any other deficiency in a mortgage application.
Interest rates and the five Cs of credit: Understanding the connection
Just as lending isn’t all about your income or credit score, choosing a loan isn’t all about rates, either. Some borrowers are overly focused on low interest rates. But in most situations, there are other loan considerations that are more important.
For example:
- Speed of closing. In a competitive bidding situation, a higher rate may be worth it if the lender can close and fund the loan in days, rather than weeks.
- Pre-payment penalties. Some loans may have a higher rate, but don’t penalize you if you sell or refinance the property before the loan term is up. If you plan on selling or refinancing, this feature may be worth paying a higher rate. Note that for Florida residents as in many other states, pre-payment penalties are prohibited for owner-occupied properties.
- Deferred payments. For construction loans, the lender may offer low or no payments during the construction period. This may be more than worth a higher interest rate.
- Low documentation. Some lenders can approve loans with little or no income verification. Or a limited appraisal.
- Openness to different property types. Some properties just don’t qualify for traditional bank financing. For example, non-warrantable condominiums with low owner-occupancy levels, new construction condos, large-acreage rural residential properties, short-term rental properties, or developments that have pending construction defect litigation are more difficult to finance.
These types of properties are riskier for the lender. Interest rates on loans on these properties will reflect that additional level of risk.
Borrowers should know that many times “advertised” interest rates are just “teasers.” Very few people can actually qualify for advertised rates, which usually assume excellent credit, perfectly verifiable income, adequate collateral, and down payments.
If you need some underwriting flexibility from a lender in one or more of these Five C’s, you may need to be more flexible with the interest rate and loan terms. If you need a lender to be more understanding and willing to look at the totality of your financial situation when considering your loan, it’s a good idea for borrowers to be more willing to look at the totality of the loan package, rather than fixate completely on the interest rate.
Many times, these loans are a short-term solution. It’s very common for borrowers to refinance to a lower-rate, more permanent loan shortly after acquiring the property.
Flexibility in lending: The role of the five Cs of credit
As the saying goes, “The perfect is the enemy of the good.” In a fluid and competitive situation such as real estate investment, a good plan that can be executed now is better than a perfect plan next week.
By next week, the opportunity is gone.
At DAK Mortgage, we consider ourselves problem solvers. If your application isn’t exactly optimal in all five of these “Five C’s,” chances are excellent we can match you with an alternative lender or program that works for you.
To discuss your options, and to learn how we can help you get a great loan for nearly any situation, contact us today.
