Understanding the Underwriting Process: The 5 Cs of Credit

What is underwriting and what does it have to do with loan approval? We dive in to the 5 C's of Credit and how they may affect your approval and loan terms.

The 5 C's of Credit:

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

The Underwriting Process of a Loan Application

Once you have submitted everything for a loan application, the information and documents are sent to a credit analyst for underwriting, or credit analysis, before an approval decision can be made. But what do the loan analysts look at?

One of the first things all lenders learn and use to make loan decisions are the “Five C's of Credit": Character, Conditions, Capital, Capacity, and Collateral. These are the criteria your prospective lender uses to determine whether to make you a loan (and on what terms).

Character (Credit History)

Lenders need to know that you are trustworthy to pay your debts. This is perhaps the most difficult of the Five C’s to quantify, but probably the most important. Looking at Credit History is the best way for a lender to see the future.  If you are a repeat customer, the lender will consider how you have paid your past loans with them.  A credit report pulled from one of the three credit bureaus is the most frequently used tool to measure how you have paid other lenders. 

Repayment with other lenders is the primary factor that goes into generating your credit score.  But the report also shows other important factors to consider such as maxed out credit cards, and the number and type of accounts you have open. 

If there are any blemishes on your credit report – late payments, collections, judgments, tax liens, etc. – be ready to discuss with your loan officer at your first meeting. If there is a solid reason for an issue on the credit report, your lender will take that into consideration.

Conditions

Your lender will consider the conditions of the industry – the stability and sustainability of the land market in the area you are buying. Are current trends in land prices going up or down? What are current market values in the area you are purchasing for similar properties? Is the property you are wanting to purchase in line with current market value? What is your income source and does the stability of that payment source correspond to the trend of the land market?

Asking these questions allows your lender to help you make sure that your purchase is a wise investment for your future. You do not want to risk a dramatic change in the market that might put you in financial bind.

Capital (Cash Reserves and Liquidity)

Before approving a loan your lender must consider your current financial state. That is best done by looking at your balance sheet. The balance sheet is a “snapshot” of your financial position and outlines your assets (everything you OWN) and your liabilities (everything you OWE). When a lender is reviewing your balance sheet, they are assessing your ability to “weather the storm.”  Things may not always go as planned, and your loan officer wants to be sure there are enough cash reserves and liquidity (assets easily converted to cash – ie. Stocks and bonds) to pay your debts.

The loan analyst will confirm your assets by verifying your cash, savings and investments accounts, and verify ownership of real estate you already own.

They will also confirm your liabilities by reviewing the credit report, register of deeds on real estate, etc. There are times when analysts have a question and request additional verification. Do not worry – this does not mean there is a problem! The quicker you can provide what they need, the quicker they can move through the underwriting process.

In the end, they want to see that the total value of your assets is greater than what you owe. The difference in the two is known as Equity (or Net Worth). The more debt you owe (loans, open accounts, etc.) compared to your assets, the harder it will be for you to withstand additional debt.  If most of your assets are paid for, you’ll be in a better position to take on an additional loan. 

Capacity (Cash Flow)

Capacity is your repayment ability. Can you make the payments on the land loan you are requesting? To verify this, the loan analyst looks at your income sources, which determines your capacity to service all your financial obligations. Do you have adequate income to pay for living expenses, other mortgage or term debt payments, vehicles and taxes, and still have capacity for taking on the additional debt you are requesting?

The lender will look at two things:

1. Primary source of repayment. For most people, this is salaried income. The analyst will verify the reported amount and stability of your income. They will most likely need some historical information from which to build a trend, such as past tax returns or W-2s.  It is important to note that for a real estate loan, it is not necessarily required that you have held a job for a certain amount of time, as you often encounter with a home mortgage. The primary consideration is that your past earnings indicate stable future earnings.
2. Secondary source of repayment. How else will you make loan payments if the primary income source goes away? This could be a spouse’s income, rental or investment income. This is where the balance sheet ties in to the ability to repay the loan. The analyst may even consider (in a worst-case scenario) if you have assets that could be sold to repay loan debt.

Your lender does want to make sure that you can pay them back, they are also looking out for you. You have a friend in a lender who looks out for you by not allowing you to take on more debt that your income can manage.

Collateral

Lenders secure a land loan with collateral. In most real estate loans, the land itself is used for the collateral. In some cases a borrower will pledge another asset such land already owned.

Many borrowers think that Collateral is the most important “C” of the five.  However, collateral is what the lender would have to depend on to repay the loan in the event that you default on your loan (which we hope never happens!), so it only becomes important if something bad occurs. 

AgSouth has various LTV (loan to value) requirements which your loan officer will discuss. The maximum regulatory LTV for a real estate loan is 85%, but may be lower.  LTV requirements are dependent on the type of real estate collateral being pledged and the strength of the borrower.

For example, a real estate loan with an approved 80% LTV means that if the property purchase (and appraised value) is $100,000, then the loan amount will cannot exceed $80,000. The additional $20,000 must be paid for by the borrower.

An official appraisal will be ordered following the loan approval to ensure that the property appraises and can meet the loan LTV requirements.

Recommendation for Approval

Once all the components of underwriting have been evaluated, the analyst will provide a recommendation for approval. Ultimately the intent of your lender evaluating the “5 C's of Credit” in the underwriting process is an effort to make sure that the loan decision is wise for you and sound for the lender.

Questions?

We hope this information is helpful in helping you understand how lenders do credit analysis. If you're looking to purchase land, farms or homes in Georgia, North Carolina or South Carolina and have questions about the loan application process one of our loan officers would me more than happy to help. Find an AgSouth Branch near you!

Not in our territory? Find your Farm Credit Association.