Buying a home isn’t easy; after all, you have to convince a mortgage banker that you’re capable of accepting a loan. When lenders review your application, they try to determine your ability to pay off your loan. Keep in mind that they are taking a chance on you—and they need to minimize risk as much as they can. Let’s talk about the primary factors (the Five Cs) a lender looks for when you apply for a mortgage. The better you do on the Five Cs, the more likely you’ll be signing on the dotted line.
First on the list is your credit report and credit score. Lenders focus in on three specific components of your credit report.
- Payment History: The lender is unlikely to believe that you can handle large mortgage payments every month if you’ve missed payments or allowed accounts to become delinquent.
- Debt-to-Income Ratio: A lender will be more confident that you have room to comfortably fit in a mortgage payment, when you have low outstanding debt in relation to your total gross income.
- Age of Credit History: Opening a new account around the same time or shortly before you apply for a mortgage can damage your credit score. A lender might wonder why you suddenly need more credit.
Capacity looks at your financial ability to pay a mortgage. Unfortunately, having just landed your dream job isn’t going to impress lenders, because they often verify at least two years of employment. They want to know you have a stable source of income. Leaving a company is concerning and, unfortunately, career changes make you more of a gamble. A lender will likely see your brand new bakery as a higher risk than was your 8 years as a software architect.
Be prepared to provide your tax returns and answer more questions, especially if you work an unconventional job or own your own business. The type of income you generate also makes a difference. Commissions and bonuses come and go and can make your income appear less reliable.
You can make yourself more appealing to a banker by having a significant amount of money in the bank. Banks are favorable to lendees when assets are stored in what’s called liquid accounts, so you can easily withdraw money to pay your mortgage and other bills if you need to. Investment and retirement accounts also count as assets, even though you may not be able to access them as easily,. Accumulating these savings over an extended period of time will show that you are able to handle your finances and are prepared for unexpected emergencies.
Unfortunately, the last two Cs are out of your control. Conditions refers to the current state of the housing market and economy—and what you’re planning on doing with the loan. Lenders may also want to know what your reason is for buying this home. For example, renting out a home will generate you significantly more income than if you plan on it being your primary residence. Lenders want to know what outside influences may impact the value of your property and your ability to pay off your loan.
If you become unable to pay off your mortgage, collateral represents the assets that lenders can take from you. For example, they’ll want to determine how much the property is worth to the bank if the loan forecloses? The appraisal will give them the value of the home you want to buy, and what it will be worth if they seize it. The conditions of your loan help identify outside risks, and collateral helps lenders reduce that risk.
Banks consider today’s lending criteria for each transaction. Although the property’s fundamentals are still important, your net worth, liquidity, free cash flow, credit history, and financial experience play a critical role in determining whether a lender will fund the deal. By carefully reviewing and preparing your financial statements, you can position the deal for success.