The 4 Cs of Credit: What You Need to Know (2024)

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Although you may have never heard of them, the 4 Cs of credit have a big impact on your ability to get a mortgage. It’s not always fair, but your financial past plays a big part in your financial future.

What are the 4Cs of Credit?

Capacity to pay the loan back
Capital
Collateral
Credit score

Why are the 4 Cs of Credit Important?

The 4 Cs of credit are the criteria an underwriter looks at when deciding whether or not to approve a loan application. The underwriter is the person at the bank or mortgage company who evaluates loans & makes the decision.

What is Capacity?

In the instance of the 4 Cs of credit, capacity measures your ability to pay back the loan.

The mortgage processor will look at:

Your income
Your employment history
The amount you have saved in the bank
How much you already pay each month toward other debts

The 4 Cs of Credit: What You Need to Know (1)

What is Capital?

Capital is the amount of available cash you have. This would include the money in the bank, investment accounts, other property owned, and other things that can be sold for cash easily.

The mortgage holder looks at your capital as a measure of your ability to pay back the loan.

What is Collateral?

Collateral is the asset you use to secure the loan. That means that if you stop paying back the loan, the bank or loan-holder can take the asset & sell it to get their money back.

For a mortgage, the collateral is almost always the property being purchased. When a house is foreclosed upon, the bank is seizing the collateral of the mortgage.

For the lender, collateral is probably the most important of the 4 Cs of credit. If your collateral isn’t worth as much as the loan, you probably won’t be approved. A new mortgage or a refinance usually requires an appraisal of the property to make sure it’s valuable enough to justify the loan.

What is Credit?

Your credit score is a measure of how you have handled debt in the past.

A credit score takes into consideration:

On-time payments
How much you owe
How long you’ve had your credit accounts
What types of credit you have
If you have new credit accounts or credit inquiries

Credit scores range from 300 to 850. A higher credit score makes you look better to lenders, so they’re more willing to offer you lower interest rates on loans.

People who are debt-free may still need a credit score, for many reasons. Renting a home, applying for certain jobs, and more are impacted by your credit score.

What is a good credit score?

There are three credit reporting bureaus – Experian, Equifax, and TransUnion. Each independently reports your score, so there may be slight differences between the bureaus.

Generalizations of score ranges:

720 – 850 = excellent credit
690 – 719 = good credit
630 – 689 = fair credit
350 – 629 = poor credit

How does credit affect your mortgage rate?

A higher credit score signals to the mortgage company that you’re historically more responsible with your money and more likely to pay off your loan. Of course, it’s not a perfect system, and more education about the subject is needed for most people.

Improving your score by 100 points can literally save you thousands of dollars in interest over the term of your mortgage. When planning to purchase a home, improving your credit score could be worth the effort.

What if I have a low credit score?

According to Nerd Wallet, you may be able to qualify for the following types of loans with a less-than-great credit score:

FHA loans require a credit score of at least 500
VA loan lenders like a credit score of 620
USDA loans usually require at least a 640 score

You would have to qualify for the loan’s other requirements, but know that there are options if your score isn’t the best.

The 4 Cs of Credit: What You Need to Know (3)

How can I improve my chances of getting a mortgage?

In short, improving the 4 Cs of credit will help you get a mortgage or a better interest rate.

Capacity

The most obvious way to increase your capacity or ability to pay back your mortgage is to increase your income. Having more money per month makes you more attractive to the bank.

You could also decrease the amount of the mortgage you’re seeking approval for. A smaller mortgage creates smaller monthly payments, so your existing income would cover more.

Capital

Improve your capital rating by saving more before seeking a mortgage. If you have the time, save at least a 20% down payment. This will decrease the amount you need to borrow and help your mortgage application.

Of course, it’s not always possible or practical to wait until you have saved a 20% down payment. Maybe your housing needs are more critical, maybe you’re moving to an area with limited rentals, maybe you have another good reason. Just know that having a larger down payment helps.

Collateral

When seeking a mortgage, it’s important to ensure the property appraises for as much or more than the mortgage amount. You’ll almost never get approved for a mortgage for more than the appraised value of the property.

In a hot real estate market, it may be difficult to move quickly enough and get a large enough mortgage when homes are selling above asking. Unfortunately, having large reserves of cash is the best way to buy a home in a crazy market like that.

Credit score

The best way to increase your credit score is to pay off debt, which will decrease your credit utilization (the percentage of available credit you’re using). Using less than 30% of your available credit is good, 0% is better.

It’s also important to continue to make existing payments on time and not take out any additional debt when planning for a new mortgage.

Are credit counseling services legit?

Credit counseling services are groups that help you improve your credit score.

Some credit counseling services are genuinely helpful agencies; some are scams. You have to be careful when working with a service so that you don’t actually make your situation worse.

Start with the National Foundation for Credit Counseling. It’s a nonprofit that employs credit counselors and will help you for free. This is the most reputable way to get help with improving your credit score.

To avoid being drawn into a scam, don’t pay for credit counseling services. There are sketchy companies that purport to improve credit scores but won’t actually do so or will just take your money.