There is no doubt the current climate of tightened credit conditions has made applying for a home loan more challenging than ever.
However, it’s important not to let the hangover of the Royal Commission into Banking negatively affect the hopes and dreams of all Australian’s to own a property, or refinance a home loan to a better, more cost-efficient product.
Knowledge is power, and whilst there is an air of pessimism in recent times, it’s important to know the basic fundamentals of credit remain unchanged, as they have done for decades. Knowing these principals and sticking to them will assist the process of applying for a home loan and minimise stress levels along the way.
In essence, there are five tenets to lending:
- Capacity – ability to repay the loan;
- Collateral – security for the loan;
- Character – credit history;
- Capital – deposit & net worth; and
- Conditions – loan type, economy, industry.
These core principals are aptly named the ‘Five C’s of Credit’. At Ocean Edge Finance our aim is to demystify the home loan process and the following information is a snapshot of the Five C’s. Knowing the basics of the Five C’s will make it much easier to understand what’s involved when applying for a home loan.
The ability, or capacity, to repay a loan is the absolute core tenet of lending.
The banks spend a great deal of time pouring over applicant’s income, liabilities, assets, expenses, number of dependants and more to give confidence there will be no adverse financial hardship in the customer’s ability to repay the loan.
The concept underpinning capacity is called ‘responsible lending’. Terms to look out for in regard to capacity include debt-to-income ratio, or DTR (the lower the better), serviceability, sources of income, credit limits and recurring debts, to name a few.
Employment history is highly important to banks. And assessment of income varies between employee applicants, known as ‘pay as you go’ (PAYG), and self-employed applicants. PAYG applicants are generally required to provide a minimum of two recent consecutive payslips and potentially a Payment Summary (Group Certificate). Whereas self-employed applicants will need to provide tax returns and potentially financials such as profit and loss statement and balance sheet (depending on the company structure), generally over the last two financial years.
Importantly, banks apply buffers, known as assessment rates, on all forms of credit in order to stress test the customer’s ability to repay their loans at a later date in the event of rising interest rates. Numerous banks have lowered their assessment rates in recent times, which will assist when applying for a home loan as outlined in my previous blog – Regulator Relaxes Stress Test on Home Loans. Living expenses has also been in the spotlight in recent times. Banks also shade some forms of income, such as overtime, commission and allowances.
Securitised lending is another fundamental tenet of credit.
Collateral is any asset owned by an applicant, usually property, of which the bank can take ownership and later sell in the unlikely event the borrower defaults on repaying their debt.
Secured loans are seen as less risky by the bank and, therefore generally come with lower interest rates and better terms than unsecured forms of credit, such as a personal loan.
Important concepts to understand in regard to collateral is Loan to Value Ratio (LVR) and Lender’s Mortgage Insurance (LMI). The bank looks at the debt relative to the value of the property, represented as a percentage, and they call this the LVR. If the LVR is more than 80%, as in the level of debt is greater than 80% of the value of the property, they see this as high risk and charge the client LMI. This LMI actually indemnifies the bank in the event of a shortfall between the sale price and recouping the total debt.
On one hand LMI is looked upon negatively as the customer is forced to pay for insurance in order to protect the bank and not themselves. On the other hand, LMI is highly beneficial, as it allows the borrower to purchase a property far quicker than he or she otherwise would given only a small per-centage of the property price needs to be saved in advance. Importantly, LMI is capitalised into the overall loan amount, so it is not considered an out-of-pocket expense.
Other important factors when purchasing a property and calculating LVR is Stamp Duty and bank fees. The amount of deposit will affect the LVR and determine if LMI is required. For refinances an independent valuation firm values the property, which is weighed against the applicant’s loan amount request in order to calculate the LVR.
Where LVR has become contentious in recent times, especially in Perth, is declining property values and the problems this creates for current home loan holders. If a property devalues too much there is potential to put customers in negative equity, meaning their LVR is greater than 100%. Selling the property would see a shortfall in paying out the debt, so unless there are savings available to make up this shortfall the borrower may need to consider bankruptcy.
Property location, types of properties, the Title and types of Titles as well as guarantees are all considerations when banks look at collateral.
The bank uses credit reporting agencies to determine a customer’s character in regard to repaying debt. In Australia, these agencies include Experian, Dun & Bradstreet and Creditorwatch.
The recent introduction of comprehensive credit reporting (CCR) allows banks to see information about how much an applicant has borrowed in the past and whether they’ve repaid their loans on time. Collection accounts, bankruptcies, directorships and proprietorships are also contained in the reports.
Credit scores are generated based on information found in the applicant’s credit report
A history of refusals and credit defaults, overdue accounts and judgements will have a significant negative effect on a home loan application.
Other areas of character the banks look at include employment stability and time spent at a particular address.
There is nowhere to hide when it comes to credit history, so at Ocean Edge Finance we reinforce to our clients the importance of disclosing any potential adverse credit history information as soon as possible.
Banks look at an applicant’s net worth, which is calculated by adding the value of any assets and subtracting any liabilities.
In short, the bank wants to know the applicant can manager his or her financial affairs.
Instrumental in a bank’s decision-making is the applicant’s ability to genuinely save a deposit when purchasing a property. A general rule-of-thumb is a minimum of 5% of the purchase price needs to be genuinely saved over a minimum of three months in advance of purchasing a property.
Banks look very favourably on applicants who have saved 20% or more of the purchase price as well as Stamp Duty and application fees, making the loan a maximum of 80% of the value of the property, known as previously mentioned, an LVR of 80% or less. This gives banks great comfort and avoids the applicant having to pay LMI.
In certain instances, first home buyers struggling to save for a deposit will see their parents offer to guarantee the home loan. In this instance, If the first home buyers default on their home loan repayments the parents guarantee to take over payment of the debt. The parents also allow the bank to take a mortgage over their property as further security to satisfy the bank.
Conditions of the loan include interest rate, loan term, minimum and maximum loan amounts, repayment types such as principal and interest or interest only and interest types such as variable, fixed or a combination of the two.
Lenders may also consider conditions outside of the borrower’s control in their decision-making when assessing a home loan application, such as the state of the economy, industry trends or pending legislative changes.
At Ocean Edge Finance we work with our clients to find out their needs and wants in a home loan depending on various factors, such as whether our client is purchasing a property, refinancing a home loan, a first home buyer, upgrader, downsizer and so on. From there we collate the particular documents required to make an assessment. We then provide options to our clients to give them the best chance of a successful application.
Underpinning our motivations in assisting clients in demystifying the home loan process and ensuring an enjoyable experience with minimal stress levels. The ultimate outcome is allowing our customers to enjoy the fun parts of purchasing a property or refinancing to save money. And, as we say at Ocean Edge Finance, “we love beating the banks.” Rest assured, we won’t rest until the best deal possible is found.
Having a basic understanding the Five C’s of Credit is an excellent start in the research stage of applying for a home loan, whether to purchase a property or refinance.
Find out more
Don’t hesitate to contact the friendly team at Ocean Edge to discuss the Five C’s of Credit further. Our office is in East Fremantle and we encourage clients to make an appointment and discuss home loan requirements in a friendly environment.