MORTGAGE BROKING
The Five C’s of Credit Analysis
BY PETER ANDREWS, MBA, CPA, B.ECONOMICS, B.ARTS
Former lecturer at Macquarie University
Peter Andrews is a specialist trainer in
Financial Planning.
After an early career in corporate finance
and banking, Peter became a lecturer at
Macquarie University.
He has also taught in the Graduate
School of Management at the University
of Sydney and the School of Banking and
Finance at the University of New South
Wales.
Peter has a Bachelor of Arts and a
Bachelor of Economics from the
University of Sydney and a Master of
Business Administration from the
University of Florida. He is also a
Certified Practicing Accountant.
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MB6 – The Five C’s of Credit Analysis PA 010615
T he previous chapter looked at the various stages of the lending
decision, beginning with the role a mortgage broker plays. The most
important part in the process is the credit decision – the decision to
lend. Since the introduction of the NCCP Act, when the borrower is a retail
client this has had to be conducted in essentially three stages – the
preliminary assessment by the mortgage broker, the final assessment by
the lending institution, and (if carried out separately), the credit review by
the lending institution. What we have not been discussed so far are the
considerations that are important when the credit decision is made.
While the credit evaluation process may be reviewed as a cycle, it is also
worthwhile looking at the characteristics that have to be considered when
a credit analysis is carried– the so-called ‘5 C’s of credit analysis. These
consist of Character, Capacity, Capital, Collateral and Conditions.
The five C’s will now be introduced and then considered individually.
CONTENTS
INTRODUCTION TO THE FIVE C’S OF CREDIT ANALYSIS. ................... 2
CHARACTER ....................................................................................... 2
CAPACITY .......................................................................................... 2
CAPITAL ............................................................................................ 2
COLLATERAL....................................................................................... 2
CONDITIONS ...................................................................................... 2
HOW THE FIVE C’S ARE ASSESSED...................................................... 3
CHARACTER ....................................................................................... 3
CAPACITY .......................................................................................... 3
CAPITAL ............................................................................................ 5
COLLATERAL....................................................................................... 6
CONDITIONS ...................................................................................... 6
 2 6. MORTGAGE BROKING
INTRODUCTION TO THE FIVE C’S
The five C’s of credit analysis are illustrated in the
2 responsible lending provisions of the NCCP Act, which
following diagram:
Figure 1: The five C’s of credit analysis
2 normally being regarded as a circumstance of financial
Character
Conditions Capacity
Collateral Capital
These will now be discussed individually, beginning with
Character.
CHARACTER
Character is the moral obligation that a borrower feels
to repay the loan. Since there is not an accurate
quantifiable measure to judge character, the lender will
decide subjectively whether or not the applicant is
sufficiently trustworthy to repay the loan. This involves
investigating the applicant’s past payment experience,
reviewing a credit bureau report, and considering the
applicant’s educational background and (if relevant)
experience in business. The quality of references and
the background and (if relevant) experience of
employees will also be considered.
Character and Capacity (covered next) are the most
important of the five C’s.
CAPACITY
Lenders need to determine whether the applicant can
comfortably manage the repayments. Past income and
employment history are good indicators of ability to
repay outstanding debt. Income amount, stability, and
type of income may all be considered.
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MB6– The Five C’s of Credit Analysis PA 010615
In the past, banks were prepared to place greater
reliance on the strength of the security offered for the
proposed loan. This, however, is contrary to the
are designed to ensure that repayments can be made
without financial hardship, with selling the family home
hardship. Further, banks have found that it can take a
considerable amount of time and money in realising the
security in satisfaction of the amount of the
outstanding loan.
Consequently, lenders have moved their emphasis from
lending against security to lending against cash flow.
CAPITAL
Capital refers to the capital contribution that the
borrower proposes to make in the total investment. An
investment is usually financed partly by loans and partly
by the capital contribution of the borrower.
With housing loans, banks usually require the owner to
contribute at least 20% of the total investment. That
way the value of the property will be less likely to fall
below the value of the loan, thereby giving rise to a
“negative equity” situation, with the loan being worth
more than the property value and the borrower
consequently being less inclined to keep up payments.
COLLATERAL
Collateral consists of property or other assets that have
been given as security for a loan.
Collateral, and sometimes third party guarantees, are
forms of security a borrower can provide. Collateral is
regarded as a secondary source of payment that can be
relied on if the borrower’s cash flows are insufficient – a
“second way out”. In the case of personal loans, the
collateral is likely to be the asset being purchased, with
the asset being seized on and sold by the bank if the
borrower defaults.
The literal meaning of collateral is “along side”. A
security exists alongside a loan.
CONDITIONS
“Conditions” refer to external conditions, mainly
national and local economic conditions. It is usually not
a strong consideration with housing finance.
 3 6. MORTGAGE BROKING
HOW THE FIVE C’S ARE ASSESSED
An important consideration with any advance is the
3
structure the loan will take. With standardized
consumer loans, the structure is likely to be determined
at the time of initial application. In contrast, with more
3
complicated loans, particularly business loans, the
structure may not be finally determined until the time
of the final credit analysis, and this may be after lengthy
negotiation.
It is not possible to point to everything that might be
considered when assessing a housing loan. However,
some of the points that are more frequently looked at
are considered below.
CHARACTER
Character is assessed by looking at:
 credit history using a credit reference agency
report: and
 employment and residence history.
The credit check is always likely to be inevitable.
Applicants should disclose and explain any instances of
past credit impairment when they apply for a loan.
Some lending institutions are prepared to go ahead
with credit-impaired loans, but only when there has
been complete honesty on the subject.
Example – Use of credit reports
The largest source of credit information on individuals
and companies in Australia is Veda, which claims on its
website (in 2013) to hold information on 16.5 million
credit active people and 4.4 million businesses.
The Privacy Act 1988 gives consumers the right to
obtain a copy of their own credit file free of charge if
they have been refused credit, or to assist them in the
management of their own individual credit standing.
Under the Privacy Act also, credit information may only
be released with the individual’s consent. To meet this
requirement, bank consumer loan application forms
invariably include a clause that authorises the bank to
obtain confidential credit information about the credit
applicant and also to exchange that information.
Employment and residence history are sought as
indications of stability. Examples of indicators of
acceptable status are:
 P.A.Y.G. employment – a minimum 6 months in
current employment. If less than 12 months in your
current employment, previous employment must
have been for at least 2 years and in the same field.
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MB6– The Five C’s of Credit Analysis PA 010615
 Self employed – at least 2 years trading in the
current business.
 Residence – preferably at least 2 years at current
address (address changes will be considered, but
usually more than three addresses in the previous
two years will be scrutinised heavily by the lending
institution).
CAPACITY
Lending institutions need to determine whether the
applicant can comfortably service the repayments. To
do this, they will use current income figures (not
expected income) and perform a calculation called
serviceability. Each lending institution has its own
method of calculating serviceability, and hence total
lending capacity varies depending on the lending
institution.
An assessment of serviceability begins with an
examination of income and expenditure.
Income
The following table provides an indication of how a
lending institution may access different forms of
income or different types of employment. The lending
institution will perform various checks with the
applicant’s employer, or previous employers, to verify
the information he/she provides to them.
Table 1: Assessment of different forms of income
Wages Lenders usually accept 100% of this figure.
Bonuses Lenders may accept bonuses if they have been
consistently earned during the last two years
Rent Lenders usually accept up to 75% of the rent received as
income (this makes allowances for vacant periods)
Interest Lenders may accept interest income if it has been
regularly paid over the last two years, otherwise it is
usually disregarded.
Dividends Lenders may accept dividend income if it has been
regularly paid over the last two years, otherwise it is
usually disregarded.
 4 6. MORTGAGE BROKING

Expenditure (with some practice), but the calculator that is relevant

for your purposes is the “loan amortization” calculator
An assessment of relevant expenditure items is shown that is available on the “Easy mode” page. If you key in
4 in Table 2. the same data as in the previous example you will
receive the same answer.
Table 2: Assessment of different forms of expenditure
4 Existing Loans Monthly repayments are required for all loans.
Figure 2: Finding the repayment amount using the
Credit Cards A nominal repayment may be applied. If, however,
Echoboom app
the applicant has a record of paying off such debts
promptly, they may be ignored.
Rent The lender makes allowances for continuing rental
commitments
Maintenance Monthly maintenance expenses are included in
serviceability calculations
HECS/PELS Higher education debts are included in
serviceability calculations
Cost of living Each lender calculates the applicant’s cost of living,
based on family size, number and type of motor
vehicles, educational expenses etc. Tables
provided by the Australian Bureau of Statistics
(ABS) may be used.
New Loan Each lender calculates expected loan repayments,
repayments and with a loading added to the interest rate (1.5 -
2%) as a buffer for future interest rate rises. This
buffer helps the loan provider feel more
content that in the event that interest rates rise in
the future, the applicant will be able to make the
required increased repayments.

With income and expenditure information, it is possible

to assess whether the applicant can afford to make the
loan repayments. First, however you have to know how
to work out the regular repayment amount of a loan.

Calculating the Repayment Amount

Many websites provide a home loan repayment
calculator. One that can be recommended is:
http://www.yourmortgage.com.au/calculators/
Other, similar websites can be found with very little
searching.
Example – Calculating home loan repayment
amount
Assume a loan of $300,000 over 30-year with monthly
repayments and an interest rate of 6%. Keying the
relevant data into the relevant places will give you a
monthly repayment of:
$1,798.65
These days there is another way to do it. That is to use a
smartphone application. One that is very simple has
been developed by Echoboom Apps and is available for
less than $4 in both Apple and Android application. It
has a financial calculator as one option and a financial
calculator can be used to calculate loan repayments
A smartphone app has strong advantages over a web
page because (a) calculations are likely to be faster; and
(b) wherever you are, you are likely to have it with you.
The interest rate you use in repayment calculations
should be what is known as a “sensitised” interest rate.
This is two per cent or so above the current variable
interest rate. This is particularly so at the time of writing
(mid-2014) when interest rates are low. It is an estimate
of the likely long-term rate plus a margin to allow for
the possibility that rates will become higher.
The only other point to note when doing interest rate
calculations is to make sure that your calculator is
adjusted for monthly interest compounding.
Measures of capacity
The traditional way to measure an applicant’s capacity
to repay a housing loan is to calculate the applicant’s

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 5 6. MORTGAGE BROKING

“surplus” after all income and outgoings, including loan Example – Debt to income ratio
payments, have been taken into account. This is
sometimes called the “net income method”. In the previous example, gross monthly income is
5 $85,000/12 = $7,083 and loan repayments are $1,998.
Example – Net income method The debt-to-income ratio is 28%, which would make the
5 Monthly income and expense details for a loan loan just acceptable by the normal American standard.
applicant are shown in the table below. The debt-to-income approach is easily applied, avoids
Income $ Expenses $ subjectivity and allows for greater automation in the
Salary ($85,000 after 5,361 Proposed loan 1,798 loan approval process. There is no evidence, however,
tax) repayment that it is commonly used in Australia.
Car allowance (net) Other loans

Commissions, bonus Credit cards 200 CAPITAL

(net)
Partner's income (net) Rates, utilities,
insurance
Family allowance Living expenses
Total 5,361 Total
Surplus 1,363
With this approach, each set of figures would have to
be assessed individually to determine if the indicated
surplus indicated sufficient capacity. In this example, a
decision would most likely be made that there was
sufficient capacity.
An approval method that takes into account both
income and expenses has its merits, but it doesn’t lend
itself to automated lending systems. It also requires an
estimate of living expenses, which for the most part is
subjective.
An alternative approach, which is American in origin
and is used by the US Federal Housing Administration, is
to calculate a debt-to-income ratio (or DTI). The debt-
to-income ratio is the percentage of (usually gross)
income that goes toward paying debt and is calculated
as follows:
monthly debt spending / monthly income * 100
35% is generally regarded as the normal safe upper
limit, with higher percentages indicating a need for debt
reduction and even credit consulting. American housing
lenders generally set lower percentages as the
maximum safe limits when they approve housing loans.
For example:
 30% of gross monthly income for single income
families
 25% of gross monthly income for dual income
families
(The lower percentage for dual income families allows
for the risk of the second income being lost).
Capital, which is the third of the “five c’s” we are
500 looking at, refers to the capital contribution that the
borrower proposes to make in the total investment. An
1,500 investment is usually financed partly by loans and partly
3,998 by the capital contribution of the borrower.
For credit assessment purposes, capital may be
considered in two ways. The first way is to consider the
financial strength of the client by examining their net
worth by subtracting their liabilities from their assets.
The second way is to measure capital as a measure of
the contribution the applicant will make to the
purchase of the property. This is achieved by using the
loan to valuation ratio (LVR), which is calculated as:
Loan amount / Property value = LVR (as a percentage)
The LVR determines the maximum amount the client
can borrow on a property and, consequently, the
minimum amount they must contribute themselves.
In the case of housing loans, for example, it is common
for lenders to expect an LVR of at least 80%, although
some are prepared to go as high as 95% if lenders’
mortgage insurance is in place.
Example - LVR
$600,000 (loan amount) ÷ $800,000 (property value) =
75% (LVR)
With personal lenders, it is wise to check that the
capital being provided is derived from savings rather
than a borrowing, perhaps from a relative. This check
can be carried out by looking at savings history, for
instance by reviewing previous bank statements, to
ensure that the amount being contributed is actually a
capital contribution, for example by reviewing previous
bank statements. If the applicants have not managed
the discipline of regular savings, they may not be able

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 6 6. MORTGAGE BROKING

to manage the discipline of making required loan may want them to provide a guarantee from a relative
payments. to support their loan application.

6 Under both the NCCP Act, the loan provider must be

COLLATERAL
satisfied that the guarantor:
Collateral is also referred to as “security”.
6  has been properly advised; and
In the case of mortgage lending, the property being  properly understands the consequences of being a
purchased is normally accepted as adequate security guarantor. Failure to do this may result in the
for the loan, provided that the borrower has been able guarantee being set aside by a court of dispute
to make an adequate equity contribution. ombudsman.

Real estate mortgages are registered with the
appropriate land titles office
(or equivalent) in each
State or Territory
Lenders Mortgage Insurance
Lenders mortgage insurance (LMI) is likely to be
required for LVR’s of above 80%. This is taken out by
the loan provider, who pays a once-off premium that
may then be passed on to the borrower. LMI protects
the loan provider against loss caused as a result of
default by a borrower where the security property
needs to be sold to recover the debt but its sale fails to
clear the debt. It covers loss of principal, unpaid interest
and all reasonable recovery costs (such as legal fees,
selling costs, etc.)
Other Forms of Security
Lenders mortgage insurance will usually be the first
resort in enhancing the security that is available, but in
some situations it may not be enough. In particular,
there may be a second mortgage.
A second mortgage is a second loan on a property. The
second mortgage holds the same rights to the property
as the first mortgage, only they are subordinated to the
first mortgage, so if the borrower goes into default, the
first mortgage is paid off before the second mortgage.
For this reason, most lenders require personal
guarantees to be accompanied by a statement from an
independent solicitor or legal adviser that they have
explained the nature and contents of the document to
the intending guarantor, who appears to understand
their obligations under the contract.
CONDITIONS
“Conditions” refer to external conditions, mainly
national and local economic conditions. How likely is it
that housing loans will rise? Housing loan interest rates
in 2014-15 are at record lows, indicating that when
housing loan interest rates are “normalised” through
increases in the Reserve Bank cash rate some
borrowers may have difficulty maintaining housing loan
repayments. It therefore makes sense to test the
capacity of borrowers to maintain housing loan
payments if they are higher because of interest rate
increases.
The definition of “conditions” for this purpose should
not be confused with loan approval conditions imposed
by lenders, such as repayment and close of credit card
accounts, or repayment of personal loans.

Guarantee
A guarantee is not really a form of security because it
does not provide assets that can be sold by the
mortgagor. Instead, it is simply an undertaking by a
third party to be liable for the debts of the borrower in
the event of default. Sometimes, however, security may
be taken over the assets of the guarantor.

Guarantees may be required in consumer lending. For

example, if the assessment of the applicant’s “character”
or “capacity” does not meet the lender’s criteria, a
third-party guarantee may provide the additional
security required. For example, a young person without
credit history may want property finance. The lender

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