Would you lend money to yourself?
What criteria would you use to decide if it’s worth taking the risk of lending yourself money?
If you plan to apply for mortgage finance, be it for your new home or an investment property, it would be helpful to understand the criteria lenders use to assess your loan application to improve your chances of getting the loan that you want.
Banks and lenders basically work to a standard measure that is known as the 4 C’s of credit in the finance industry:
So let’s look closer at what each of the 4 C’s represent and how they impact the bank’s verdict on approving your loan application.
When banks refer to a loan applicant’s “character”, they are not referring to whether you happen to be a nice, caring person who volunteers their time for charity or the like.
Essentially they want to know if you take your financial commitments seriously and can repay the loan and they do this by looking at your credit history. They try and answer questions like:
- Will you repay the loan and meet your monthly obligations in full and on time?
- Have you used credit before and if so, how much and for what purpose?
- Are your financial facilities in order?
- Do you have a history of paying bills on time or are you consistently defaulting and playing “catch up”?
- Are there any judgments against you with regard to bad debts or have you been declared bankrupt in the past?
- How stable is your employment?
- How stable are your living arrangements?
- How many credit inquiries have you made and over what timeframe?
Many of these factors that go toward determining your character are assessed using your credit file.
Your credit file
Everyone who has ever applied for any type of finance, be it a credit card, mobile phone account, personal loan or home loan has a credit file registered against their name.
Whenever you apply for credit, the credit assessor will obtain your credit file to determine whether you have a good or bad credit rating – this tells them all about your lending “character”.
Basically that’s because lenders want to make sure that they will get their money back.
Your credit file is run by a company called Veda Advantage. The good news is you can go to their website www.mycreditfile.com.au to request a copy of your credit file, which outlines things like:
- Any loans you have applied for in the past 10 to 15 years
- References to bad credit you may have had in the past seven years
- Bankruptcies or judgments
- Current and historic directorships in companies
- Past residential addresses
- Historical employment data
In other words, it makes you pretty much transparent to the bank, with your credit file telling a fairly detailed story about your behaviour in the finance world.
All lenders and mortgage insurance companies have access to this file, and when applying for a loan, you give them authority to delve into your credit history. This is one of the very first steps in the assessment process.
Why shopping around can sabotage you
While many people like to “shop around” for a good deal when it comes to securing credit, thinking they are getting the best interest rate, the problem with this is it can damage your credit rating and financial character.
You see, if you’ve applied for numerous loans within the last six to twelve months, these multiple inquiries are a red flag to credit assessors; particularly if all the inquiries are for the same amount. Even though there may be a legitimate reason for this activity, such as shopping around to find a good deal, lenders simply perceive you as a high risk applicant.
Their interpretation is that you must have been knocked back by all of those other lenders you approached and then they might start digging deeper to find out why. Or worse still, may just decide to decline you without any further investigation.
If you have four to six inquiries on your credit file within the past six months, the banks may perceive you as a bad credit risk and deny you funding.
One of the best ways to avoid this is to engage the services of a proficient finance broker to do the shopping around on your behalf.
They can help you secure the best deal possible on interest rates, fees and charges. More importantly, you will get the best product for your specific circumstances and you won’t have multiple inquiries on your credit file.
You should also check your credit file before applying for any type of loan to make sure there are no glitches that could harm your chances of obtaining credit.
Stability equals success
When it comes to the banks assessing your lending character, your employment history will be closely scrutinized.
People who have jumped from job to job are seen as a higher risk by lenders, whereas applicants who have remained with the same employer for three to five years are looked upon much more favourably.
Banks are also less willing to give funds to people who have just started in a new position where there is a probationary period. For this reason, if you are planning to purchase your first property, upgrade, or access equity in existing properties to build an investment portfolio, it’s always advisable to apply for a loan before changing jobs.
Often contractors or self-employed people have more difficulty getting loans. Again, the banks just want to make sure you can repay your loans and may ask forfinancials statements, copies of old bank statements or details of trading account statements. This enables them to calculate how much income you could derive from your business.
The second “C” of credit is collateral; what you are offering the lender as security over your loan. For investors or homebuyers, this would be a property.
Of course lenders favour certain properties over others when it comes to assessing a loan application. Is the collateral you are offering them a 15 square metre bedsitter or is it a four bedroom mansion in a blue chip suburb?
Specialised properties like student accommodation, a serviced apartment or a small one bed apartment are not considered preferred security by the banks, meaning you might be limited in regard to the loan you can get, if they will even give you one at all.
They may only be willing to look at a maximum Loan to Value Ratio (LVR) of 65 to 70%, or the loan could come with a higher interest rate, the loan term could be reduced from 30 to 20 years and it is unlikely you would be offered an interest only product.
Another factor is location – a property in a blue chip suburb in one of our large metropolitan cities is far more attractive to lenders than real estate in regional or rural Australia.
Essentially the banks are stringent with their assessment of the size, type and location of the property you intend to use as collateral because for them it comes down to the question of how much they can get if everything goes pear shaped and they are forced to sell the asset.
Your capacity to repay the loan is the third “C” and is commonly referred to as serviceability; where the bank looks at your employment income, either PAYG or self-employed, any rental income and all of your assets and liabilities.
The way banks assess your employment income is pretty self explanatory. They simply look at how much you have coming in each month and deduct from that how much you have going out for things like general living expenses (groceries, rent or mortgage, utilities, etc.), personal loans and credit card debts.
Did you know that with regard to credit and store cards the way the banks look at it is – the higher your credit limits, the less capacity you have to meet your loan commitments in the eyes of the banks.
Even if you don’t max out your cards, in the bank’s eyes you have the capacity to, so when it comes to the way the banks assess your serviceability and how much they will lend you, your existing credit limits makes a big difference. For instance, a $20,000 or $25,000 credit card limit may reduce the amount you can borrow by as much as $70,000 or $80,000.
Now when it comes to assessing rental income from your investment portfolio, lenders’ policies can vary significantly. A handful of lenders might be willing to take into account 100% of your rental income when considering your level of serviceability.
On the other hand, many of the big banks will limit the amount of rental income that goes toward their assessment of your ability to service the loan to as little as 75% of your rents.
That’s because they factor in variables that can cause rental income to go up or down, such as vacancy periods, property management and insurance costs and things like maintenance and repairs.
Although this may not seem like a significant issue, think about it this way: if you have a property portfolio generating a rental income of $100,000 per annum and one bank uses that entire $100,000 to assess your ability to service your loans, whereas another bank uses only $75,000, that means you have a gap in your borrowing capacity of nearly $350,000 at current interest rates.
Essentially, this difference could mean that by borrowing from the bank that allows a more generous assessment of your rental income (at 100%), you are able to buy one extra property to add to your investment portfolio.
The fourth and final “C” is your capital or deposit.
The more “hurt money” you put down, in other words the bigger the deposit, the lower the Loan to Value Ratio (LVR). If you are seeking an 80% LVR or lower (meaning you have a 20% plus deposit), then credit is relatively easy to come by. However, if the LVR you’re aiming for exceeds 80%, then the application has to be submitted to a mortgage insurer to cover the bank’s risk
Essentially it’s all about getting your ducks in a row and ensuring you present the lender with an application that is hard to reject based on their specific assessment criteria. By doing so, you have a far better chance of securing that all-important finance to buy your next home or build a lucrative property investment portfolio and meet your wealth creation goals.
Think about it – isn’t that the type of person you’d rather lend your money to if you were a bank?