Thursday, September 10, 2009

The High 5's of Credit

When you are looking to borrow you need to consider that the economic climate will dictate how a lender will look at a deal. How the lender will come to the decision to approve a deal is different in 2007 as to what it is in 2009. Here are some basics if you are going to apply for credit and what you should consider.

Lenders are in business to make (not lose) money. Consequently when a bank lends money it wants to ensure that it will get paid back. (the same as a borrower expects to come out of the end of a transaction with more than they went in with). To maximize the possibility of being paid back, the bank wants to make sure that there is sufficient assurance that a person can and will pay back a loan. The lender must consider the 5 "C's" of Credit each time it makes a loan.

Is the general impression you make on the potential lender. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan. Your educational background and experience in your field of work will be included. The length of time at your current employment and your current residence will be considered. The longer you have been at both, the higher you will score on the character scale. In 2007 there was little concern that your future might be in jeopardy. In 2009 every source of income is scrutinized as whether it is feasible that it will continue.

Is the extra security the lender has to cover the loan. In real estate transactions this generally means the property. If for some reason, you cannot repay the mortgage, the bank wants to know that the real estate the mortgage was taken out for is good and marketable real estate. A current real estate appraisal will determine the value for the property in today's market. Some lenders will limit themselves to the type of property they are going to accept. In the case of a foreclosure or Power of Sale, the lender doesn’t get the property. They have to apply to the courts to have them placed back on the market for resale to repay the loan. This takes time and money. Lenders will charge for the risk accordingly.

Is the money you personally have invested in the purchase, otherwise known as your down payment. The more of your own money you invest as a down payment, the more likely that you will do all you can to maintain your payment obligations. Owners with the smallest downpayments present the greatest risk and accordingly the highest CMHC Premiums. Capital is also reflected by your ability and willingness to save money and accumulate assets. The higher your net worth, the more you have as a buffer for repayment in the event you run into a financial set-back. Saved or earned capital is more highly regarded than borrowed funds.

Is the evaluation of your habits in performing credit obligations. The information about your credit history is stored at the "credit bureau" and indicates how well you paid your bills over the last 6 years. All major credit cards, auto loans, leases etc. are reported to the credit bureau. A lender will evaluate your ability to maintain your obligations and try and determine how well you live within your means. Some individuals make the mistake of not paying the minimum monthly obligations on loans and credit cards with the expectation of making a larger payment the following month. These missed payments appear on their credit report branding them as chronic "late-payers" for the next 6 years.

To repay the loan is probably the most critical of the five factors. The lender will want to know exactly how you intend to repay the loan. The lender will consider your income as it relates to the loan that you are applying for. Does the monthly carrying costs of the loan represent less than or equal to 32% of your total monthly income? If it is, the probability of you successfully repaying the loan is fairly high. When you include your personal debts, loans, cards, etc., a lender will likely not approve your total debt load of higher than 40% of your total monthly income. Prospective lenders will also want to know about any other sources of income you may have to repay the loan, if your steady income stream is interrupted. What savings can you fall back on? What property do you have that you could sell to cover payments?
The biggest factor that people are having the most difficult time with today: These principles above change completely depending on what the future economy is predicted to do. For the past few years we have had a rising economy. Increasing property values. More fear of people losing their jobs. Even if they do, the value of their property has risen so they can sell and get out of trouble. Now we are in the midst of a declining economy. It is expected that in the near future many jobs will be eliminated. House sales will fall along with the value of homes. Yet this has not been the case.

Chris Molder from Tridac Mortgages points out that in many countries other than Canada it is difficult to obtain a mortgage on a purchase with less than 50 or 60% of the purchase price as the down payment.

Our strong financial system in Canada provides a 5% minimun downpayment program with a CMHC Mortgage Insurance fee payable. No Banking institution is permitted to advance greater than 80% of the purchase price or appraised values.

When I was in the Trust Company (Financing Commercial Transactions) Corporate lending policy post the '81 and '82 interest rate peaks were limited to 66% of the appraised value. I wonder how that would change things today if everyone needed 35% down.

Your comments are invited.

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