The five Cs of credit in action

This year, I have had the pleasure of speaking at several stops of the MPC Symposium series, where I discussed the impact that the B-20 guidelines are having on our industry and alternative lending. As part of my presentation, I looked at how B-20 was likely to further increase the alternative mortgage business and how brokers can better position themselves to capture more of this growing market segment.

During the Q&A sessions, and especially in the conversations I had with attendees afterwards, the discussion focused on how brokers with limited experience in the alternative space can recalibrate their focus to expand their Alt-A business. My feedback to these brokers was that the underlying principles for preparing an Alt-A application are essentially the same as for a prime mortgage, but when it comes to Alt-A deals, it is necessary to provide a more complete story to the underwriter.

Factor in the more stringent qualifying requirements in place now, and it is even more critical to provide as much detail and context as possible. We have to not only validate income, but also verify it and determine the overall creditworthiness of the borrower and their capacity to service the mortgage.

Naturally, this led to two questions: First, just what did I mean by “tell a more complete story”, and how can Home Trust approve deals other lenders decline? These two questions are very much related, as I’ll discuss in a moment.

But before we get into that, let me be clear that Home Trust does not approve deals that other lenders reject simply because we’re willing to take on more risk. What we are willing to do, however, is to spend the necessary time to fully understand the details and get to know the applicant.

Our record speaks for itself: Home Trust’s default rate is on par with, or better than, the prime financial institutions. This is testament to the expertise of our underwriting process, and it is this factor that differentiates Home Trust from many other alternative mortgage lenders.

The five Cs of credit and risk-based pricing
The five Cs are, in reality, just another form of the standard ‘know your client’ approach used to some degree by all financial institutions. This process is critical in the application of risk-based pricing, where the interest rate offered by the financial institution reflects the credit risk associated with a particular file.

Understanding each of the five Cs, and how Home Trust has slightly enhanced each one to align with our specific business model and risk appetite, will provide you with a better view on how to package a mortgage application with the details required by our underwriting team.

Character
An applicant’s character, including credit history and credit score, is the primary means by which underwriters evaluate the creditworthiness of an individual. This is an important indicator, and many lenders will reject an applicant whose credit score falls below their threshold without any further review. Home Trust also places significant weighting on credit scores, but in situations where an applicant’s score is lower than ideal, we want to review the circumstances leading to the credit downgrade.

For instance, commonplace occurrences such as a prolonged illness or a divorce can negatively impact an applicant’s credit. In order to understand the events leading to a credit downgrade, we need to understand both the cause of the downgrade and, more importantly, the cure.

Using divorce as an example, divorce proceedings are, by their very nature, tremendously disruptive, not to mention extremely costly. Assets can be tied up for a prolonged period as the process to determine the division of matrimonial property works its way through the legal system.

However, if you can show that the applicant will receive assets such as the proceeds from the sale of the matrimonial home once the divorce is finalized, this can provide a cure for the applicant’s credit concerns. This is a prime example of where brokers should include that extra level of detail in the application notes to provide the additional information our underwriters need to resolve potential problems that, without a sufficient explanation, could result in the application’s denial.

Capacity
Capacity is about more than just income. What we want to see here is that the client has the ability to service the loan. This is especially important for those with irregular incomes, as this involves a much deeper examination of income than simply looking at a couple of recent pay stubs.

For instance, clients who are self-employed or who work in positions where a significant portion of their pay is derived from commissions or performance bonuses can see wide fluctuations in their month-to-month income. This can make it challenging to assess an applicant’s true capacity and is one of the reasons why many financial institutions decline those with such income arrangements.

Home Trust specializes in lending to those with irregular incomes, and our many years of business-for-self experience allow us to accurately evaluate a self-employed client’s capacity. In evaluating the client’s income, we take into consideration such things as cash flowing through bank accounts, outstanding invoices, pending orders and liquid assets to help verify that the client’s business is a going concern and is operating from a strong financial position.

Of course, we need documentation to support this review, and we routinely work with our broker partners to gather the approved documents required to support the mortgage application.

Collateral
Collateral refers specifically to the property that is being purchased. As the actual security for the loan, this is an important consideration, and our underwriters spend significant time reviewing all aspects of the property.

We require an accurate valuation of the property, and we need specifics – including location, age and overall condition – to determine a value. We also require this to be verified by an approved third party.

In addition, we look at how the property conforms with the local neighbourhood, as the surrounding area has a considerable impact on the true market value. We also take note of the pride of ownership a homeowner places in their home. It’s not a coincidence that those who take good care of their home tend to also have a good track record of repayment.

Capital
With respect to capital, we consider the type of employment and the applicant’s tenure in that position; available assets, including other properties and liquid assets; and overall net worth. As I discussed in the capacity section, for applicants with irregular incomes, available capital can be very helpful in bolstering the application.

One of the scenarios we routinely see involves recently retired individuals planning to purchase their retirement home. In some cases, they may require a short-term mortgage to purchase the new property, as they intend to stay in their current home until they’ve had a chance to complete the necessary renovations to turn their retirement home into their dream home.

Because they can now only declare their retirement income – which is typically less than the income they earned while working – they may have difficulty qualifying for the amount they wish to borrow. However, in addition to their stated retirement income, they also have sizeable liquid assets in the form of accumulated savings, as well as their existing home, which they intend to sell once renovations on their retirement home are complete.

In this case, it is clear that the individual has sufficient additional assets to ensure they can afford the mortgage, despite having a relatively moderate regular monthly income. This is a very common example of how Home Trust assesses all five Cs together to get a complete and accurate picture of every applicant.

Conditions
Finally, there are the conditions – the underlying aspects of the deal, including the terms of the mortgage and the supporting documents required to provide confirmation of the applicant’s finances, as well as the property itself. Because this touches on the other categories, I see conditions as the element that brings all five Cs together to provide the complete story for our underwriters.

With confirmation of these important considerations, the underwriter can determine if it is appropriate to move forward with the deal. If so, the final conditions of the mortgage offer, including the approved principal amount, the interest rate and the term of the mortgage, are included in a commitment letter for the broker to share with the client.

Tying it all together
I hope this overview of how Home Trust uses the five Cs of credit has been helpful in explaining the importance of telling a complete story. I also hope it shows how Home Trust uses this information to make an extremely well informed decision on all alternative mortgage applications we receive and how we are committed to working with our broker partners to provide, where possible, a positive result for the client.

In order to do this, however, we rely on you to provide the extra detail we need to review the file. Supporting documents and the inclusion of additional notes within the application are the means by which you can provide this information, which ultimately gives us the full story for each application.

If you have any questions about our use of the five Cs of credit or need assistance with any other matter, please contact your Home Trust representative, who will be more than happy to provide you with additional guidance. Thank you for your continued support, and let’s all get ready for what is already shaping up to be a busy summer season.

Mike Forshee is Home Trust’s senior vicepresident of residential underwriting.