3 Chapter 3 – Consumer Credit Analysis: The Five Cs of Credit
Learning Objectives
LEARNING GOALS
Upon completion of this chapter, you should understand:
- the five Cs of credit.
- how to apply the five Cs of credit to a lending application.
- how to identify the common red flags in a lending application.
Consumer credit analysis is the process in which a lender collects required information to determine a client’s creditworthiness.
Banks and financial institutions write loans and mortgages every day to be paid over a term length agreed upon with the client. The challenge for lenders is that they cannot predict the future. The decision to grant credit is based on the information provided at the time of the credit application. Due diligence on the part of the lender is required to ensure a deal is sound, well constructed, that all precautions were taken, and that any indicated risks were properly mitigated.
When a loan or mortgage goes into default, the credit files for that loan are reviewed to ensure that all proper processes and procedures were completed at the time of the credit application. Financial institutions prefer to minimize loan losses, as their goal is to create value for their shareholders. Significant loan losses do not sit well with shareholders. Auditors can also review credit files as part of normal security processes; they are ensuring all necessary policies and procedures are being followed. A lender should always strive to submit a solid credit file; they want to ensure their credit deals do not get called into question.
Lenders have long used a framework called the five Cs of credit to help them analyze a client’s situation to determine their credit worthiness. Lenders use this framework to help predict their client’s future behaviour. Note that there are some variations of the five Cs of credit; the authors have chosen the framework commonly used for consumer credit in Canada.
The Five Cs Framework: CHARACTER/CAPACITY/CAPITAL/ CREDIT/COLLATERAL
CHARACTER
Stability of Employment
A client’s time at their employer is critical to the entire credit application. The lender should always ask, “Will we get repaid?” Clients should have three years with the same employer because this indicates stability. However, there could be reasons for a client not meeting the three-year benchmark for employment. Lenders need to review and determine if the client is still in the same line of work. If not, the lender will need to determine the reason for the career change. Did they change careers to improve their prospects and life? Did they just graduate university and land their first job? All this information is critical for the credit file. If a client does not have three years of employment stability, this is concerning and could be considered a red flag.
Time at Residence
The benchmark here is to have three years at the same residence. Three years plus shows stability and is preferred in lending. If the client has moved multiple times and does not have three years at a residence, the lender will need to ask the client for an explanation. Some reasons can be justified and, therefore, mitigated. The rationale needs to be included in the credit submission.
Owning versus Renting
Lenders view owning a home as an excellent sign of credit. It shows the client was able to qualify for a mortgage in the past and is now maintaining a mortgage.
Educational Background
A client’s educational background is something that lenders review as it can impact their ability to earn income. It should be determined if a client’s education aligns with their career choice. If it does, it indicates that the client believes in investing in their future.
Asset and Liability Mix
The status of a client’s financial situation at a given point in their lives indicates a client’s financial maturity. For example, a client is in their 30s and has established a good mix of assets and liabilities. In the case of this client, their financial situation demonstrates their financial maturity. Lenders like to see that clients have established RRSPs, TFSAs, and other investments while also balancing their debt load.
CAPACITY
Capacity is defined as the financial ability to pay debts when they are due. For capacity, lenders want to see if a client’s debt ratios are in line and determine if the client has stability with employment and their ability to earn income.
Can the client repay this debt? To determine this C of credit analysis, the lender will analyze the client’s information, calculate their income versus debt, and use debt ratios to determine their ability to pay back their debt.
GDS cannot exceed 39%.
TDS cannot exceed 44%.
Note: GDS and TDS ratio guidelines can vary between financial institutions based on their lending criteria. For the purposes of this course, we will use the above ratio guidelines.
Lenders calculate a client’s TDS ratio prior to a new loan request. This helps the lender determine the client’s current situation and if the client has the capacity to take on more debt. If their initial ratio exceeds the required limit, the lender should review the client’s situation to determine if a debt consolidation would help the client’s capacity. Debt consolidation could help achieve the client’s initial credit request.
Financial institutions have a required calculation they use to determine the value for heat. Some institutions calculate it as 0.06 x the square footage of the house. In this course, we will use a flat value of $120 for our debt ratio calculations. Property tax is typically retrieved from a client’s property tax statement, but for course purposes, the value for property tax will be provided in the cases and activities found throughout the course.
Note: If a client indicates their rate of pay is about to change due to a raise, the lender can only use what can be verified. Current income would be used until the new pay rate can be shown (per the income verification requirements).
CAPITAL
Capital is defined as a client’s long-term financial strength to pay. The lender considers all of the client’s assets and liabilities. The lender will ask the client for a list of the assets financial institutions deem acceptable for lending purposes. Assets considered acceptable to a financial institution are:
|
Real Estate |
Automobiles |
Investment Accounts |
Accounts |
|---|---|---|---|
|
Lender needs client’s primary residence and any other properties (recreational/rental) |
Year/Make/Model |
Term Deposits, RRSPs, GICs, TFSAs, Mutual Funds, Discount Brokerage Accounts, Pensions |
Chequing and Savings Accounts |
The lender will collect all of the liabilities in the client’s name. What if a client neglects to share a liability and it is discovered later by reviewing their credit bureau report? In this case, the lender will need to determine if this was an oversight by the client or if they intentionally withheld the information.
|
Mortgages |
|
Home Equity Line of Credit |
|
Unsecured Line of Credit |
|
Loans (RRSP, Student Loans, Renovation Loans, Other) |
|
Credit Cards |
When the lender assesses the client’s assets to liabilities, they will determine the client’s capital position. This is done by determining the client’s net worth position. The net worth position should correlate to the client’s age and employment. A higher net worth demonstrates prudence and reinforces character. If a client presents with a negative net worth, the lender must mitigate this position. If the client is young and establishing themselves, it is expected that they will have a negative net worth as they build up their asset base. However, if a client has a negative net worth but is older and should be established, the lender needs to look into the client further.
CREDIT
In the five Cs, credit refers to how the client chooses to use credit. Consider the client’s purpose for the credit being requested. Also, look at their current use of credit and the availability of existing credit. This C is usually evaluated by using a credit bureau supplied by a credit reporting agency. The two main credit reporting agencies in Canada are Equifax and TransUnion.
|
The cost of using credit reporting agency information; these costs can vary. |
|
The sources of information. Are they accurate? |
|
NSFs, collections, and payment history |
|
Credit bureaus do not make assessments of anyone’s capacity to handle credit. |
|
Credit reporting agencies merely collect and sell information. |
|
Advantages |
Disadvantages |
|---|---|
|
Available immediately |
Some information may be inaccurate, missing, or old |
|
Low bias – # of creditors |
No information on new businesses/people |
|
Good history available |
|
|
Cheaper to get a report than to get all information |
You can further review the topic of credit bureaus by clicking the following link and reviewing the document Understanding Your Credit Report and Credit Score. Choose “Continue to publication” to see the document.
COLLATERAL
COLLATERAL
Collateral is a major consideration in the process of granting credit. Collateral is often used to mitigate the level of risk in a deal. The client is asked to pledge an asset to the lender to enhance the promise to repay. If the client is not able to follow through on the loan agreement, the asset is seized and liquidated to satisfy the debt. Collateral represents something tangible that can be pledged for a loan. Security is a claim (or right) that the borrower has voluntarily assigned to the lender to reduce the lender’s risk. A co-signature of a guarantor represents security but not collateral.
The Personal Property Security Act (PPSA)
- The Personal Property Security Act (PPSA) brings together, under one roof, legislation that was previously embodied in several acts. Who has title to the asset is now irrelevant.
- It encompasses the various types of security documents that create security interests in property, except real estate, which is registered with land titles (e.g., PPSA does not cover collateral mortgages)
- PPSA includes chattel mortgages, conditional sales, floating charges, pledges, trust deeds, assignment (securities), and certain consignments.
- A bank or seller must register a financing statement with personal property.
- Registry is required to maintain a security interest in the goods.
- A security interest is NOT enforceable against a third party unless the debtor has signed the security agreement that has a description of the collateral (with serial number).
- One security agreement can create a security interest for part or all of the debtor’s personal property, both present and future.
How Would You Pledge the Following as Collateral for a Consumer Loan?
Value of the security vs. amount of loan.
Concerns when realizing your security?
Seizing – Claiming – Liquidating.
The type of collateral used for a credit file has implications for the interest rate. An asset that is considered of better quality and liquidity could result in a reduction of the interest rate.
1. Vehicle
- Down payment? Age of vehicle significant? A new vehicle is considered to be less than four years old. A used vehicle is anything older than four years of age.
- The ability to use an older vehicle as collateral depends on the strength of the deal.
- It provides commitment by the debtor as an incentive to pay.
2. Property
- residential property
- first mortgage
- second mortgage (total loan/value < 80%)
- recreational property (location)
3. Government Bonds
- note value changes
- 70% value
4. Life Insurance.
- Must have a cash surrender value
- A significant amount of paperwork
- SDB
6. Mutual Funds
- Money Market – 100% value
- Bond Funds – 70% value
- Equity Funds – 50% value
7. Stocks
- Blue Chip – 50% of value
- Penny Stock – too risky
8. Term Deposits/GICs
• 100%
Usually only allowed as collateral if the GIC/Term Deposit is at the same financial institution. The Advisor will take a statement of the GIC/Term Deposit, and register a message on the banking system to indicate that the investment is held as collateral.
Not Considered Collateral
- Personal guarantees or co-signors are not considered collateral but can be added to a credit file to strengthen the deal.
- RRSPs are protected by bankruptcy legislation.
- Stereo equipment/computer equipment/camera lenses/furniture/jewelry depreciate quickly and are difficult to seize and liquidate.
Questions for the Lender
How much security does the bank need? It depends on the liquidity and value of the security/collateral.
When can the financial institution lend unsecured? The following reasons will allow a financial institution to issue an unsecured loan: high net worth (20%), high income, an excellent banking relationship, and when the loan is not for consolidation.
What happens if the bank takes too much security? If a loan is over secured, the financial institution can’t keep liquidation value in excess of the debt owed.
Red Flags in Lending
As a lender gets more experienced in completing a client’s credit analysis, they will be able to identify certain factors that are considered red flags. These are things that the lender should watch out for and pay close attention to.
Signs of Credit Risk
Undisciplined Spending Habits
Look at the credit bureau to see the type of credit requested in the past or review the client’s bank account statements to identify trends. Beware of clients who request a debt consolidation loan to pay off credit cards and then re-open or re-apply for credit cards and start accumulating more debt.
Unstable Employment
If a client has instability in their employment (multiple jobs not in the same industry) or frequent job changes, the loan may not be repaid. The risk is higher for individuals who are unemployed, seasonal, or on government assistance. The lender must ask questions about the client’s unstable employment when determining the client’s ability to repay the debt being requested.
Client Misrepresentation
Clients may provide incorrect or incomplete information. They may inflate their income or neglect to disclose all of their debt. Sometimes this is unintentional; however, if it is determined that this is deliberate, the credit request should be declined.
Negative Net Worth
When a client presents with a negative net worth (more liabilities than assets), more scrutiny is required by the lender. The lender may need to look into assisting the client with a debt consolidation. This will allow them to start saving money and build up their net worth.
Mitigating Risk
|
Closely conform to credit guidelines at all times. |
|
React quickly and appropriately to changing client situations. |
|
Keep your guard up; trust your instincts. |
|
Do not advance inappropriate credit out of pity for a client. |
|
Verify that all necessary client documentation is in good order. |
|
Be alert for discrepancies and irregularities. |
|
Investigate all irregularities thoroughly. |
|
Document all inquiries and aspects of the investigation. |
|
Resist a client’s insistence on urgent approvals. |
|
Treat the bank’s money as you would your own. |
Trust your instincts; intuition never lies.
– Oprah Winfrey
Media Attributions
- image (12)
- image (13)
- image (14)
- image (15)
- image (16)
- image (17)
- ChatGPT Image Jun 26, 2025, 01_51_51 PM
- image (18)
- image (19)
- image (20)
- image (21)
