Collateral and Capital

Collateral and capital are the final two components of the 5 Cs of credit. The other three have been discussed in my previous articles.

Collateral

Collateral is a form of security for the lender. Banks require collateral as a type of insurance in the event that you cannot repay the debt. If you default on the loan, the lender takes possession of the collateral in exchange for the debt. In the case of a mortgage, the collateral used is your house.

The amount of funds you can borrow in relation to the value of the property is called the loan-to-value ratio (LTV). This typically ranges from 65% to 95%. It all depends on the property, the borrower's overall creditworthiness and the purpose of the request. For example, let's say you are buying a home for $400,000. The minimum down payment is $20,000, or 5%. This would leave you a mortgage balance of $380,000 (plus default insurance, which is an article for another time). For simplicity, let's assume the mortgage balance is $380,000. This means the loan-to-value is 95% ($380,000 divided by $400,000).

If you want to refinance your mortgage, the maximum loan-to-value ratio is normally 80%. This means that if your home's appraised value is $400,000, you would be able to borrow up to $320,000, which is 80% of $400,000. The equity that you build in your home can be utilized in several different ways. With the rising value of real estate in the past couple of years, it is a great time to tap into that equity.

Capital

The last component of the 5 Cs of credit is capital, which is essentially your net worth. This is the easiest of all calculations that are used in the mortgage world. Add up all your assets and subtract your debts. Easy as that! Are you in a positive net worth position? If so, the lender looks at it as though you have cash, property or investments to liquidate if times get tough.

Do not sweat it if you have a negative net worth, as it could be for a positive reason. Perhaps you have student debt, which is realistically an investment for your future. It is the reason you are making money! Lenders will take this into account with all the other Cs as part of the decision making process.

It is important to know that lenders look at all components when assessing whether or not they are prepared to extend credit. You may lack in one area and excel in all the rest. The areas that are lacking should be justified, as it gives the lender some insight into your situation and how you got there. Having an understanding of what the lender's expectations are prepares you for your future financing experiences.

Originally published Apr 14, 2018. Rates, programs and rules mentioned reflect that time; for today's numbers see the rates page or ask Tisha.