Solved Financial and Mortgage Broking

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Copyright 2015© Mentor Education Group Pty LtdMB6 – The Five C’s of Credit Analysis PA 010615MORTGAGE BROKINGTheFive C’sof Credit AnalysisBY PETER ANDREWS, MBA, CPA, B.ECONOMICS, B.ARTSFormer lecturer at Macquarie UniversityPeter Andrews is a specialist trainer inFinancial Planning.After an early career in corporate financeand banking, Peter became a lecturer atMacquarie University.HehasalsotaughtintheGraduateSchool of Management at the Universityof Sydney and the School of Banking andFinance at the University of New SouthWales.PeterhasaBachelorofArtsandaBachelorofEconomicsfromtheUniversityofSydneyandaMasterofBusinessAdministrationfromtheUniversityofFlorida.HeisalsoaCertified Practicing Accountant.he previous chapter looked at the various stages of the lendingdecision, beginning with the role a mortgage broker plays. The mostimportant part in the process is the credit decision – the decision tolend. Since the introduction of the NCCP Act, when the borrower is a retailclient this has had to be conducted in essentially three stages–thepreliminary assessment by the mortgage broker, the final assessment bythe lending institution, and (if carried out separately), the credit review bythe lending institution. What we have not been discussed so far are theconsiderations that are important when the credit decision is made.While the credit evaluation process may be reviewed as a cycle, it is alsoworthwhile looking at the characteristics that have to be considered whena credit analysis is carried– the so-called ‘5 C’s of credit analysis. Theseconsist of Character, Capacity, Capital, Collateral and Conditions.The five C’s will now be introduced and then considered individually.CONTENTSINTRODUCTION 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 BROKINGCopyright 2015 © Mentor Education Group Pty LtdMB6– The Five C’s of Credit Analysis PA 010615222INTRODUCTION TO THE FIVE C’SThefiveC’sofcreditanalysisareillustratedinthefollowing diagram:Figure 1: The five C’s of credit analysisThese will now be discussed individually, beginning withCharacter.CHARACTERCharacter is the moral obligation that a borrower feelstorepaytheloan.Sincethereisnotanaccuratequantifiable measure to judge character, the lender willdecidesubjectivelywhetherornottheapplicantissufficiently trustworthy to repay the loan. This involvesinvestigating the applicant’s past payment experience,reviewing a credit bureau report, and considering theapplicant’seducationalbackgroundand(ifrelevant)experience in business. The quality of references andthebackgroundand(ifrelevant)experienceofemployees will also be considered.Character and Capacity (covered next) are the mostimportant of the five C’s.CAPACITYLenders need to determine whether the applicant cancomfortably manage the repayments. Past income andemployment history are good indicators of ability torepay outstanding debt. Income amount, stability, andtype of income may all be considered.Inthepast,bankswerepreparedtoplacegreaterreliance on the strength of the security offered for theproposedloan.This,however,iscontrarytotheresponsible lending provisions of the NCCP Act, whichare designed to ensure that repayments can be madewithout financial hardship, with selling the family homenormally being regarded as a circumstance of financialhardship. Further, banks have found that it can take aconsiderable amount of time and money in realising thesecurityinsatisfactionoftheamountoftheoutstanding loan.Consequently, lenders have moved their emphasis fromlending against security to lending against cash flow.CAPITALCapitalreferstothecapitalcontributionthattheborrower proposes to make in the total investment. Aninvestment is usually financed partly by loans and partlyby the capital contribution of the borrower.With housing loans, banks usually require the owner tocontribute at least 20% of the total investment. Thatway the value of the property will be less likely to fallbelow the value of the loan, thereby giving rise to a“negative equity” situation, with the loan being worthmorethanthepropertyvalueandtheborrowerconsequently being less inclined to keep up payments.COLLATERALCollateral consists of property or other assets that havebeen given as security for a loan.Collateral, and sometimes third party guarantees, areforms of security a borrower can provide. Collateral isregarded as a secondary source of payment that can berelied on if the borrower’s cash flows are insufficient – a“second way out”. In the case of personal loans, thecollateral is likely to be the asset being purchased, withthe asset being seized on and sold by the bank if theborrower defaults.Theliteralmeaningofcollateralis“alongside”.Asecurity exists alongside a loan.CONDITIONS“Conditions” refertoexternalconditions,mainlynational and local economic conditions. It is usually nota strong consideration with housing finance.CharacterCapacityCapitalCollateralConditions

6. MORTGAGE BROKINGCopyright 2015 © Mentor Education Group Pty LtdMB6– The Five C’s of Credit Analysis PA 010615333HOW THE FIVE C’S ARE ASSESSEDAn important consideration with any advance is thestructuretheloanwilltake.Withstandardizedconsumer loans, the structure is likely to be determinedat the time of initial application. In contrast, with morecomplicatedloans,particularlybusinessloans,thestructure may not be finally determined until the timeof the final credit analysis, and this may be after lengthynegotiation.It is not possible to point to everything that might beconsidered when assessing a housing loan. However,some of the points that are more frequently looked atare considered below.CHARACTERCharacter is assessed by looking at:credithistoryusingacreditreferenceagencyreport: andemployment and residence history.Thecreditcheckisalwayslikelytobeinevitable.Applicants should disclose and explain any instances ofpast credit impairment when they apply for a loan.Somelending institutions are prepared to go aheadwith credit-impaired loans, but only when there hasbeen complete honesty on the subject.Example – Use of credit reportsThe largest source of credit information on individualsand companies in Australia is Veda, which claims on itswebsite (in 2013) to hold information on 16.5 millioncredit active people and 4.4 million businesses.ThePrivacyAct1988givesconsumerstherighttoobtain a copy of their own credit file free of charge ifthey have been refused credit, or to assist them in themanagement of their own individual credit standing.Under the Privacy Act also, credit information may onlybe released with the individual’s consent. To meet thisrequirement,bankconsumerloanapplicationformsinvariably include a clause that authorises the bank toobtain confidential credit information about the creditapplicant and also to exchange that information.Employmentandresidencehistoryaresoughtasindicationsofstability.Examplesofindicatorsofacceptable status are:P.A.Y.G. employment– a minimum 6 months incurrent employment. If less than 12 months in yourcurrent employment, previous employment musthave been for at least 2 years and in the same field.Selfemployed–atleast2yearstradinginthecurrent business.Residence– preferably at least 2 years at currentaddress (address changes will be considered, butusually more than three addresses in the previoustwo years will be scrutinised heavily by the lendinginstitution).CAPACITYLending institutions need to determinewhether theapplicant can comfortably service the repayments. Todothis,theywillusecurrentincomefigures(notexpectedincome)andperformacalculationcalledserviceability.Eachlendinginstitutionhasitsownmethod of calculating serviceability, and hence totallendingcapacityvariesdependingonthelendinginstitution.Anassessmentofserviceabilitybeginswithanexamination of income and expenditure.IncomeThe following table provides an indication of how alendinginstitutionmayaccessdifferentformsofincome or different types of employment. The lendinginstitutionwillperformvariouscheckswiththeapplicant’s employer, or previous employers, to verifythe information he/she provides to them.Table 1: Assessment of different forms of incomeWagesLenders usually accept 100% of this figure.BonusesLenders may accept bonuses if they have beenconsistently earned during the last two yearsRentLenders usually accept up to 75% of the rent received asincome (this makes allowances for vacant periods)InterestLenders may accept interest income if it has beenregularly paid over the last two years, otherwise it isusually disregarded.DividendsLenders may accept dividend income if it has beenregularly paid over the last two years, otherwise it isusually disregarded.