Collateral and Capital

Collateral and Capital are the final 2 components of the 5 C‘s of credit.  The other 3 have been discussed in my previous articles. 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%-95%.  It all depends on the property, the borrowers overall creditworthiness and the purpose of the request. For example, lets 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,  lets assume the mortgage balance is $380,000. This means the loan to value is 95%($380,000/$400,000).  If you want to refinance your mortgage the maximum loan to value ratio is normally 80%.  This means,  that if your homes 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 years,  it’s a great time to tap into that equity.

The last component of the 5C‘s 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. Don’t 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’s the reason you are making money!  Lenders will take this into account with all the other 5C‘s 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 of your situation and how you got there.  Having an understanding of what the lenders expectations are prepares you for your future financing experiences.