The 5 C’s of credit every first-time homebuyer should know

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In a Nutshell

If buying a house seems like a daunting process with too many moving parts, it’s time to simplify. And that’s where learning the five C’s of credit can help you.

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A first-time homebuyer can easily get lost in the weeds when applying for a home loan, which is why we recommend starting with the basics: the five C’s of credit.

“Wait a second,” you might be asking yourself. “The what?”

The five C’s of credit are character, capacity, capital, collateral and conditions. Lenders may use all or some of these characteristics to determine your creditworthiness before approving a loan.

Learning these five characteristics can help prepare you for one of the biggest investments you’ll ever make. How? Because looking at them side-by-side can help you fill in the blanks on everything from your credit history to how big a down payment you’ll need to get the mortgage you want.

Let’s check out the five C’s of credit and see how they can help make you a smarter first-time homebuyer.


The 5 C’s of credit

  1. Character
  2. Capacity
  3. Capital
  4. Collateral
  5. Conditions

Character

“Character is often measured by your credit.”

Benjamin Keys, Assistant Professor of Real Estate, Wharton School of the University of Pennsylvania

In the days of Model T’s and ice-cream socials, it was easier for everyone in a community to know who was — and who wasn’t — a high-risk customer for a loan. Basically, it was easier to know who had character.

Today, “character is often measured by your credit,” says Benjamin Keys, assistant professor of real estate at the Wharton School of the University of Pennsylvania. “And credit scores are a key metric.”

Your credit reports contain information about your credit accounts and transactions. A lender can look at your credit reports to learn how often you make payments on time and how many accounts (credit cards, auto loans, student loans, etc.) you have in good standing.

A credit score is a three-digit number that reflects the information in the corresponding credit report. Knowing what goes into your credit scores and reports can be the first step to improving them so that you can make a good impression on potential lenders.

Keep in mind that there are multiple providers, each of which may use different scoring models to generate scores. That means that your scores might differ depending on the model and provider. Also, during the underwriting process a mortgage lender will probably use a different scoring model than the ones available on Credit Karma.

What’s in a credit score?

Action steps:

  • Check your credit reports and verify that all the information is accurate and current. Credit Karma offers free credit reports from two of the major consumer credit bureaus, TransUnion and Equifax. You may also be able to dispute any errors you find on your TransUnion® credit report through Credit Karma’s Direct Dispute™ tool. You’ll have to file a dispute with Equifax directly if you see an error on your Equifax® credit report. Don’t forget that your lender may use a different report than the ones available on Credit Karma, but you should still check for errors to get a baseline idea of what sort of problems might be lurking on other reports.
  • Check your credit scores. On Credit Karma, you can get your free VantageScore 3.0 credit scores from TransUnion and Equifax. Remember, your lender may use a different score than the ones available on Credit Karma. Nonetheless, checking your scores on Credit Karma can help you get a directionally accurate view of your credit.
  • Find out how lenders might categorize your scores. Some lenders group scores into ranges, explains Keys. If your scores are within sneezing distance of a higher (read: less expensive) mortgage rate category, it could pay to wait and work on improving your credit health, says Keys. In the eyes of lenders, better credit could mean that you’re less likely to default on a loan. Being seen as less risky could result in a more favorable interest rate.

Capacity

Your capacity is based on your financial ability to repay the mortgage.

“Capacity is usually measured by income and employment,” says Keys.

Lenders may review your most recent federal tax return, along with several pay stubs and a few months of bank statements, to verify your income.

The other factor they’ll likely assess in relation to your income and employment is your stability. Part of that relates to how long you’ve had your job, says Barry Zigas, director of housing policy for the Consumer Federation of America.

That bit of information may seem a bit irrelevant, but most lenders want to see proof that your income is stable and consistent.

Lenders may also look at your debt to income ratio (also known as your DTI ratio). This metric helps them evaluate how much additional debt you can handle and how much of a credit risk you pose. Though your DTI ratio isn’t one of the key factors used to calculate your credit scores, it can still have a significant impact on your ability to get credit.

To figure out your DTI ratio, first add up all your monthly debt obligations. (These may include your monthly credit card payments, loan repayments and other financial obligations, such as alimony.) Then divide the sum by your monthly pretax income.

FAST FACTS

The ideal DTI ratio for getting a mortgage

There’s no “magic number” when it comes to the ideal DTI ratio for first-time homebuyers. The preferred range varies by lender, but there are some general limits you’ll want to note. The Consumer Financial Protection Bureau recommends a DTI no higher than 43% to get a qualified mortgage. And in May 2017, Fannie Mae recently raised its maximum DTI for borrowers to 50% from 45%. Keep in mind, though — that’s the max. We recommend trying to keep your DTI ratio below 43% to stay on the safe side.

Action steps

  • If your DTI ratio is higher than you’d like, try to lower it. The two ways to do so are to pay off your debt or increase your income. Consider asking for a raise, refinancing your loans or even taking on a side hustle if you have the time.
  • Build a healthy savings account. A large amount of money or liquid assets can compensate for a less attractive DTI, says Zigas.
  • Limit your search to homes that fit your circumstances and abilities, rather than the maximum amount you can afford to pay.
  • Before you commit to a house, calculate the specific expenses associated with it. This may include everything from repairs and upkeep to property taxes, utilities and insurance, says Zigas.

Capital

Capital is the money you have left after you buy a home, along with any investments, properties and other assets you could liquidate fairly quickly.

Why it’s important: Even though a home is likely the largest purchase you’ll ever make, lenders generally don’t want you to clean out your bank accounts to buy a home.

“If you don’t have cash in the bank after you’ve bought a house, you could be vulnerable,” explains Zigas. Even if it’s not required by your lender, a cash cushion can act as a shock absorber for everything from home repairs to a job loss.

Oftentimes, mortgage lenders will frame your savings in terms of a certain number of mortgage payments you have in the bank, says Keys. But the specific number they like to see varies.

Action steps

  • Recognize that a down payment is only part of buying a home. It’s smart to save as much money as you can so you can comfortably make future mortgage payments and cope with the regular costs of homeownership, like repairs and taxes.
  • Ask about the expected cash reserve. When you interview potential mortgage lenders, ask each how much money in your bank accounts they want to see.

Collateral

Collateral is something of value that secures a loan. When you get a mortgage, the collateral is typically the home itself.

“The collateral is basically what the lender is depending on in the event the borrower can’t repay the loan,” says Zigas.

One reason lenders usually require a home appraisal (and sometimes an inspection) is that they want to be sure that the house’s value “supports the mortgage,” he adds.

Action step

  • Shop collateral requirements when you compare mortgage terms. “The myth that a lot of homeowners believe is that they have to put 20%” down, says Keys. But the Federal Housing Administration, Fannie Mae and Freddie Mac have home loan programs for borrowers who want to put down less than 4%. But note that there are requirements and qualifications for these programs based on the loan amount, down payment and property conditions. And the U.S. Department of Veterans Affairs backs a portion of the home loans to veterans and their families that don’t require a down payment. Be aware, however, that mortgages with less than a 20% down payment are often accompanied by private mortgage insurance, which is an extra monthly expense added to your mortgage.

Conditions

The fifth C looks at the market conditions that serve as the background music to your home purchase. While the other four C’s are personal to you, this fifth C is the “big picture” stuff.

“Conditions” can include everything from interest rates and mortgage rates to cost of living and how many homes are on the market in your area.

The real estate market is very local. So it can help to understand the supply-and-demand situation in the areas and price ranges you’re targeting. In a “buyer’s market,” where supply exceeds demand, you often have more leverage to bargain because there are a lot of houses available, so it can become more difficult for sellers. In a “seller’s market,” where demand exceeds supply, the seller may have the upper hand.

Action steps

  • Get preapproved for a mortgage. One rookie mistake: Shopping for a home and then applying for financing. Instead, try to shop for financing first. The lender will fully vet you for a mortgage and give you a preapproval letter for a specific loan amount. Preapproval can help you move faster when you do find the home you want. And with preapproval already in hand, you’ll likely be viewed as a more attractive buyer.
  • Comparison shop for the best mortgage deal. About 77% of homebuyers apply to only one lender, according to data from the Consumer Financial Protection Bureau. With an often six-figure purchase, says Keys, “it’s worth doing some shopping to make sure you’re getting the best possible value.”

If you want to really shop around, investigate a variety of lending sources, including large and independent banks, credit unions and mortgage companies. Then ask what types of mortgages they can offer. And have a shopping list for the talking points that are important to you — like rates, collateral, capital reserves, DTIs and credit score requirements.


Bottom line

Ultimately, the five C’s of credit boil down to a sixth C: confidence. Namely, a lender’s confidence “that you can pay your debt,” says Zigas.

But knowing the five C’s of credit can also give you confidence at a crucial time. (Sort of like having the exam questions in advance for the big test.) You can use them to help you prepare, shop smart, and select the home and mortgage that will best fit your life and your finances.