What are the 4 C’s of Credit for Getting a Mortgage?

Are you considering getting a house, car, or personal loan this year (or in the next 2 – 3)? If so, you’re going to need to know about the 4 c’s of credit.

No, they’re not horsemen bringing the apocalypse or the top cuss words your kids will spout out in front of their kindergarten class (again). The 4 c’s of lending are markers that help lenders (like Freddie Mac) decide if you’re a safe bet for a loan.

Candidly, I’ve never heard of the 4 c’s of credit framework before, and I’ve had a handful of auto loans, home loan, and student loans. While it’s not a significant term amongst borrowers, it’s a big piece of the puzzle for lenders.

I knew that they checked your credit score from the credit bureaus and employment, but I never thought much about why they do so. It turns out lenders are checking your 4 c’s (or 5, 6 c’s of credit, depending upon who you ask) to make sure that you’re not likely to default on the loan.

So, ready to jump into what exactly the four cs of credit are, and how you can plan to slam dunk them without breaking a sweat? Let’s get started!

The 4 C’s of Credit Analysis

Without further ado, the four C’s of credit analysis are (in no particular order):

• Capacity
• Credit
• Capital
• Collateral

And, if you’re feeling extra cheeky, you can consider these as numbers 5 and 6 of the c’s of credit:

• Character
• Conditions

The 4 c’s help mortgage lenders and loan companies gauge just how much of a risk you are, and if you’ll make your loan payments. All of these add up to create a picture of your risk factor. When your picture looks good, these companies will gladly offer you a loan. If it’s not great, it can affect the conditions of the loan.

But if every one of your four C is trash? You’re out of luck. At least until you get to work fixing them.

So how do loan companies determine if you’ve got what it takes as a prospective borrower? Lenders begin by asking for various documents and information to review during the loan application process to see what your track record is like. These documents vary depending upon the type of loan you want. However, they can include:

• Employment records to see work history
• Most current pay stub
• Letter explaining any gaps in the past two years of employment; extra points if you have documentation to back it up
• Self-employed workers will need to provide two years of tax returns (and possibly additional documents depending upon your business structure)
• Social security number and birth date to pull credit reports
• Two months of bank statements, including checking, savings, retirement and investment accounts

Now that the lender has your information, they’re going to analyze it to see if you’re a good match for a loan. Here, we get in-depth of just what each of the four c’s of credit mean, and how they can work for (or against) your chances of landing a loan.

The 4 C’s of Credit Analysis: Capacity

Capacity refers to your ability to handle the loan payment. Lenders want to know:

• Are you able to make the payment? What’s your debt load now?
• Do you have a stable job?
• Do you carry high debt on your credit cards?
• What’s your monthly disposable income?

Lenders will look at a couple of things to determine this:

DTI Ratio: This is your debt-to-income ratio. They’ll add together all your minimum payments of your current balances on your monthly debts, then divide by your gross monthly income (that’s what you make before taxes).

The lower the DTI ratio, the better your chances of getting approved. A rough rule of thumb is 35% or less, however, take that with a HUGE grain of salt. Each lender varies, not to mention the other c’s of credit analysis can play into this as well.

Your DTI ratio includes monthly debts like car payments, student loans, credit card payments, personal loans, child support, alimony, any other debts that you have more than ten months left to pay.

Note: If you own a business, and depending upon how it’s structured, there is a chance that any business loans may be counted as well. Talk to your CPA, business laywer, or loan officer to find out more.

Example: You make $2,000 gross a month. Your student loan, car loan, and minimum credit card payments add up to $1,000. Therefore, your DTI ratio is 50% because your debts take up half of your gross monthly income.

Housing Expense Ratio. (This applies specifically to applying for a mortgage.) This ratio states the cost of owning a home should be 28% or less of your gross monthly income (again, a generalization, there are lots of other factors).

Lenders don’t consider utilities or garbage to be part of your housing expenses, but do consider the following to be so:

• Principle
• Interest
• Property taxes
• Homeowner’s insurance
• HOA costs (if applicable)
• PMI (private mortgage insurance; added to your loan if you are putting down less than 20% as a down payment)

Example: Your gross monthly income is $2,000. Lenders would want your total housing expenses not to exceed $560 a month (28% of your gross monthly income).

Job History and Future Job Stability. Lenders want to know that you’re going to show up for work and make that dough to support that loan payment. If you’ve been flaky with jobs in the past, they’re going to notice.

If you’re working in a shaky industry, they’re going to take note of this as well. Lenders want to be sure you have what it takes to pay during the life of your loan and that you’re likely to be gainfully employed.

To-Dos: How to Boost Your Capacity

If your capacity if looking a little rough, you can work on the following to beef it up:

1. Pay off any debts that you can quickly boost your debt-to-income ratio or housing expense ratio.
2. Boost your income by getting a better paying job or a side hustle.
3. If your housing expense ratio is too high, consider a different area with lower property taxes or a smaller house.
4. If you have gaps in your employment in the past two years, provide documentation and a letter to explain the absences.

The 4 C’s of Credit Analysis: Credit

You knew this one was coming, right? Your credit score follows you around like a ray of sunshine. (Or a rain cloud, depending upon your numbers.)

Lenders pull your credit reports and score to see if you’ve been naughty or nice. And much like Santa Claus, they can determine if you deserve a loan based on your previous actions.

Credit Reports and History. Lenders want to see if you’ve had late payments and all of the debts you’ve had before. Your payment history is an important consideration – otherwise, how can they be sure you understand how to handle debt?

The main pieces they’re looking for are late payments, outstanding loans, and borrower defaults. They want to know that when you’ve been trusted with so much money before, that you’ve acted responsibly. The credit history shows the borrower’s ability to make monthly payments on recurring debt.

Credit Score. What’s in a good credit score? These scores are an important factor in dictating the type of financing available, as well as how much of a down payment is required.

Even though there are now loans with super low down payments, if your credit score is trash, they’re not going to let you apply for these.

To-Dos: How to Boost Your Credit

Before you apply for a loan, pull your credit reports from the three big reporting agencies (TransUnion, Experian, and Equifax) and go over them with a fine-tooth comb.

1. Anything that comes back as incorrect, you’ll need to start a dispute with that agency to get it removed from your record.
2. Check your credit score for free through a service like Credit Sesame. If your credit score is low, read up on how to boost it quickly.
3. Contact any companies that you have outstanding debts with and set up a payment plan to get the debt current and stop the late payment strikes on your record.

While cleaning up your credit report is easy to do, it does take time. The sooner you start, the better everything will look to lenders when you decide to apply for your loan.

The 4 C’s of Credit Analysis: Capital

Much like a flaky ex, lenders want to know what you’re worth. They need proof that you can afford the down payment, as well as the closing costs and additional fees associated with the loan.

You’ll Need to Provide Financial Statements. Yes, it can feel intrusive to just lay your financial information out like that, but lenders need to know that you’re not living paycheck to paycheck. Lenders will ask to see:

• Checking and savings statements
• Retirement and investment accounts

They want to see that you have accounts you can quickly get into if you need to make that mortgage payment after getting laid off. While no one wants to tap their 401k to make a mortgage payment, loan companies need to know that you have back up if things go pear-shaped.

Having a down payment signals to lenders that you’re serious about doing this right and paying this loan off. It can also help save your own money because you’re able to avoid PMI (private mortgage insurance). This form of capital can also affect your rates and terms of the loan, so consider waiting to build a more significant down payment if possible.

Other means of capital can also include gifts from family members, down payment assistance programs, and grants or matching fund programs.

To-Dos: How to Boost Your Capital

Boosting your capital is essentially one step: build your savings. If you choose to receive a gift from a family member, you will need to provide documentation proving it’s a gift and not a loan.

The 4 C’s of Credit Analysis: Collateral

When you’re buying a house or car, those items become the collateral for the loan. These are called secured loans, and these debts are less risky because the lender can repossess the item if you don’t pay.

The other bright side to a secured loan is that you can also get lower interest rates and better terms because you have that collateral available if you can’t make the payments. (It’s a strange win-win, but I’ll take it.)

Knowing that loan companies see houses and cars as collateral, they want to make sure the property is worth the purchase price. Assessing collateral involves a couple of steps by third parties:

Home Inspection. Depending upon where you’re buying, a home inspection might not be required. However, it’s an excellent idea to get one anyway.

Unless you’re a contractor and know the ins and outs of housing, hire a home inspector to check for mold, termites, and the like. Both you and the mortgage company need to know what you’re signing up to take on.

Home Appraisal. This step is non-negotiable, and you’d be hard-pressed to find a lender that doesn’t require it. An appraiser will review the house and the neighborhood, while also looking at recent sales.

They’ll come up with comps that determine if the fair market value of the property and the house’s condition, which means any issues have to be fixed before the sale is complete.

Loan-to-value ratio. For cars, there’s LTV, which is the loan-to-value ratio. This ratio is how much you’re borrowing versus how much the car is worth. Clearly, the loan company doesn’t want to lose their shirts if things go south, right?

If the LTV is too high, you might be required to provide a downpayment. By doing so, you’ll lower the LTV and make the loan company more comfortable with handing over that cash.

To-Dos: How to Boost Your Collateral

There’s not much you can do proactively to boost your collateral. If a lender feels the property you want to buy isn’t up to snuff, chances are you’ll have to provide a larger down payment, or you’ll have to keep looking for a different house/car.

In all seriousness, though – do you want to want to go upside down on a loan? It might be time to rethink things if the house/car doesn’t appraise for what you’re willing to pay for it.

Additional C’s of Credit Analysis

What, wait? Didn’t I say there were four? What’s this craziness?

Depending upon the loan situation, there can be up to four more c’s of credit. I know, I know – you’re thinking, what the heck else could they possibly need to know about me? I’m not telling anyone about my underwear size. Some things should just remain a mystery.

Underwear size aside, there are two more pieces to the credit puzzle that are worth mentioning.

Bonus C’s of Credit Analysis: Character

No, we’re not talking about what your Harry Potter character name should be (though mine’s The Grey Lady of Warrington, FYI). Lenders want to know your character, as in your reputation.

This one’s not as measurable as the other C’s and isn’t entirely as black and white either. It can also be an important deciding factor if the lender’s decision isn’t clear enough.

Your character is a snapshot of your creditworthiness and is assessed by looking at your credit reports. Loan companies want to see that you’ve paid loans back in entirety and that you’re trustworthy.

Now is when your squeaky clean credit reports will come into play, as well as your FICO score. The better each are, the better your chances of getting a loan.

To-Dos: How to Boost Your Character

Again, this is your credit score and reports, so you need to make sure they’re clean. Dispute anything that you don’t think belongs, and start cleaning up anything questionable, such as:

• Late payments
• Collection accounts
• Charge-offs
• Judgments
• Bankruptcies
• Foreclosures
• Delinquent accounts

Bonus C’s of Credit Analysis: Conditions

Conditions refer to the lending terms, state of the economy, and intent of the loan. Some of these you can influence, but some you can’t.

Lending terms. The lending terms include the interest rate and amount of the loan. The better your other C’s of credit are, the better the conditions you’re offered.

The economy. Unfortunately, no one can predict the economy, and when it might take a turn for better or worse. When the housing market collapsed in 2008, it became much harder to get a loan. Loan companies cracked down on the requirements needed to get approved because they had tons of homeowners defaulting on loans.

Intention for the loan. Loans for things like houses, cars, and home improvement have a specific intent. Personal loans, however, don’t since you can use them for just about anything. Lenders like to know if a loan is secured or not, and if there’s potential collateral to back it up.

To-Dos: How to Boost Your Conditions

While you can’t control all the conditions (side-eyeing you, economy), you can control the items that influence your lending terms.

1. Make sure your debt’s paid down, and your DTI ratio is excellent.
2. Build your capital by having a larger down payment.
3. Review and clean up your credit report.

Now that you know more about how to crush the 4 c’s of credit when buying a home or car, get to work! Remember that cleaning up credit reports, saving down payments, and boosting your credit score is going to take some time. So get to it!