Solved Financial and Mortgage Broking

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Copyright 2015© Mentor Education Group Pty Ltd MB6 – The Five C’s of Credit Analysis PA 010615MORTGAGE BROKING The Five C’s of Credit Analysis BY PETER ANDREWS, MBA, CPA, B.ECONOMICS, B.ARTS Former lecturer at Macquarie University Peter Andrews is a specialist trainer in Financial Planning. After an early career in corporate finance and banking, Peter became a lecturer at Macquarie University. He has also taught in the Graduate School of Management at the University of Sydney and the School of Banking and Finance at the University of New South Wales. Peter has a Bachelor of Arts and a Bachelor of Economics from the University of Sydney and a Master of Business Administration from the University of Florida. He is also a Certified Practicing Accountant. he previous chapter looked at the various stages of the lending decision, beginning with the role a mortgage broker plays. The most important part in the process is the credit decision – the decision to lend. Since the introduction of the NCCP Act, when the borrower is a retail client this has had to be conducted in essentially three stages – the preliminary assessment by the mortgage broker, the final assessment by the lending institution, and (if carried out separately), the credit review by the lending institution. What we have not been discussed so far are the considerations that are important when the credit decision is made. While the credit evaluation process may be reviewed as a cycle, it is also worthwhile looking at the characteristics that have to be considered when a credit analysis is carried– the so-called ‘5 C’s of credit analysis. These consist of Character, Capacity, Capital, Collateral and Conditions. The five C’s will now be introduced and then considered individually. CONTENTS INTRODUCTION TO THE FIVE C’S OF CREDIT ANALYSIS. ................... 2CHARACTER....................................................................................... 2CAPACITY.......................................................................................... 2CAPITAL............................................................................................ 2COLLATERAL....................................................................................... 2CONDITIONS...................................................................................... 2HOW THE FIVE C’S ARE ASSESSED...................................................... 3CHARACTER....................................................................................... 3CAPACITY.......................................................................................... 3CAPITAL............................................................................................ 5COLLATERAL....................................................................................... 6CONDITIONS...................................................................................... 6T
6. MORTGAGE BROKING Copyright 2015 © Mentor Education Group Pty Ltd MB6– The Five C’s of Credit Analysis PA 0106152 2 2 INTRODUCTION TO THE FIVE C’S The five C’s of credit analysis are illustrated in the following diagram: Figure 1: The five C’s of credit analysis These will now be discussed individually, beginning with Character. CHARACTER Character is the moral obligation that a borrower feels to repay the loan. Since there is not an accurate quantifiable measure to judge character, the lender will decide subjectively whether or not the applicant is sufficiently trustworthy to repay the loan. This involves investigating the applicant’s past payment experience, reviewing a credit bureau report, and considering the applicant’s educational background and (if relevant) experience in business. The quality of references and the background and (if relevant) experience of employees will also be considered. Character and Capacity (covered next) are the most important of the five C’s. CAPACITY Lenders need to determine whether the applicant can comfortably manage the repayments. Past income and employment history are good indicators of ability to repay outstanding debt. Income amount, stability, and type of income may all be considered. In the past, banks were prepared to place greater reliance on the strength of the security offered for the proposed loan. This, however, is contrary to the responsible lending provisions of the NCCP Act, which are designed to ensure that repayments can be made without financial hardship, with selling the family home normally being regarded as a circumstance of financial hardship. Further, banks have found that it can take a considerable amount of time and money in realising the security in satisfaction of the amount of the outstanding loan. Consequently, lenders have moved their emphasis from lending against security to lending against cash flow. CAPITAL Capital refers to the capital contribution that the borrower proposes to make in the total investment. An investment is usually financed partly by loans and partly by the capital contribution of the borrower. With housing loans, banks usually require the owner to contribute at least 20% of the total investment. That way the value of the property will be less likely to fall below the value of the loan, thereby giving rise to a “negative equity” situation, with the loan being worth more than the property value and the borrower consequently being less inclined to keep up payments. COLLATERAL Collateral consists of property or other assets that have been given as security for a loan. Collateral, and sometimes third party guarantees, are forms of security a borrower can provide. Collateral is regarded as a secondary source of payment that can be relied on if the borrower’s cash flows are insufficient – a “second way out”. In the case of personal loans, the collateral is likely to be the asset being purchased, with the asset being seized on and sold by the bank if the borrower defaults. The literal meaning of collateral is “along side”. A security exists alongside a loan.CONDITIONS “Conditions” refer to external conditions, mainly national and local economic conditions. It is usually not a strong consideration with housing finance. CharacterCapacityCapitalCollateralConditions
6. MORTGAGE BROKING Copyright 2015 © Mentor Education Group Pty Ltd MB6– The Five C’s of Credit Analysis PA 0106153 3 3 HOW THE FIVE C’S ARE ASSESSED An important consideration with any advance is the structure the loan will take. With standardized consumer loans, the structure is likely to be determined at the time of initial application. In contrast, with more complicated loans, particularly business loans, the structure may not be finally determined until the time of the final credit analysis, and this may be after lengthy negotiation. It is not possible to point to everything that might be considered when assessing a housing loan. However, some of the points that are more frequently looked at are considered below. CHARACTER Character is assessed by looking at: credit history using a credit reference agency report: and employment and residence history. The credit check is always likely to be inevitable. Applicants should disclose and explain any instances of past credit impairment when they apply for a loan. Some lending institutions are prepared to go ahead with credit-impaired loans, but only when there has been complete honesty on the subject. Example – Use of credit reports The largest source of credit information on individuals and companies in Australia is Veda, which claims on its website (in 2013) to hold information on 16.5 million credit active people and 4.4 million businesses. The Privacy Act 1988 gives consumers the right to obtain a copy of their own credit file free of charge if they have been refused credit, or to assist them in the management of their own individual credit standing. Under the Privacy Act also, credit information may only be released with the individual’s consent. To meet this requirement, bank consumer loan application forms invariably include a clause that authorises the bank to obtain confidential credit information about the credit applicant and also to exchange that information. Employment and residence history are sought as indications of stability. Examples of indicators of acceptable status are:P.A.Y.G. employment – a minimum 6 months in current employment. If less than 12 months in your current employment, previous employment must have been for at least 2 years and in the same field. Self employed – at least 2 years trading in the current business. Residence – preferably at least 2 years at current address (address changes will be considered, but usually more than three addresses in the previous two years will be scrutinised heavily by the lending institution). CAPACITY Lending institutions need to determine whether the applicant can comfortably service the repayments. To do this, they will use current income figures (not expected income) and perform a calculation called serviceability. Each lending institution has its own method of calculating serviceability, and hence total lending capacity varies depending on the lending institution. An assessment of serviceability begins with an examination of income and expenditure. Income The following table provides an indication of how a lending institution may access different forms of income or different types of employment. The lending institution will perform various checks with the applicant’s employer, or previous employers, to verify the information he/she provides to them.Table 1: Assessment of different forms of income WagesLenders usually accept 100% of this figure. Bonuses Lenders may accept bonuses if they have been consistently earned during the last two years Rent Lenders usually accept up to 75% of the rent received as income (this makes allowances for vacant periods) Interest Lenders may accept interest income if it has been regularly paid over the last two years, otherwise it is usually disregarded. Dividends Lenders may accept dividend income if it has been regularly paid over the last two years, otherwise it is usually disregarded.

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