The 3 Câs of creditâcharacter, capacity, and collateralâare a widely-used framework for evaluating potential borrowersâ creditworthiness. By analyzing each applicant through those three lenses, an underwriter can better predict which borrowers will repay on time, and which are more likely to go delinquent or even default on their debt.
While many banks, credit unions, and other credit providers still incorporate the 3 Câs into their underwriting model, most have also taken steps to modernize their loan origination, replacing human judgements with data-driven algorithms and testing.
Given that modernization, do the 3 Câs still hold up as a conceptual framework? In this article, weâll examine each of the 3 Câs (as well as alternate models, like the 5 Câs or the 3 Râs) and discuss its relevance to modern credit and lending operations, including the tools and strategies that leading credit providers use to modernize their underwriting and decisioning.
The first C of âcharacterâ takes on a more specific definition than the general meaning of a personâs values and beliefs. Most lenders, for example, donât really care if youâre a poor sport when your team is losing or if you gossip behind your friendsâ backsâsportsmanship and kindness are good qualities, but not necessarily accurate predictors for repayment.
The key measures of character in credit underwriting come down to financial history, positive identification, and other behavior patterns.
Underwriting is one of the most critical steps in the lending process, yet it remains a mystery to many borrowers. As an underwriter examines a loan application they focus on three key factors known as the “3 C’s” – Character Capacity, and Capital. Mastering these concepts is essential for borrowers who want their loan application to sail through underwriting.
In this comprehensive guide, we’ll unpack each of the 3 C’s, explain how underwriters evaluate them, and provide tips for borrowers on putting their best foot forward. Whether you’re seeking a mortgage, auto loan, or business financing, understanding underwriting can make the difference between approval and denial.
What is Underwriting?
Underwriting is the process a lender uses to assess the creditworthiness of a borrower. The underwriter reviews the loan application and supporting documents to analyze the risk of lending money to that individual or business.
Specifically underwriters look at
- The 3 C’s: Character, Capacity, and Capital
- Credit reports and credit scores
- Verification of income and employment
- Assets and liabilities
- Collateral (if applicable)
Based on this information, the underwriter determines if the borrower meets the lending guidelines and merits approval of the loan. If the risk is deemed too high, the loan may be denied.
Underwriting protects lenders from making bad loans that won’t be repaid on time or in full. It’s in place to minimize defaults and delinquencies in their portfolio. At the same time, prudent underwriting provides credit access for qualified borrowers.
The 3 C’s of Underwriting
Underwriting examines the 3 C’s – Character, Capacity, and Capital. Let’s explore what each one entails.
Character
A borrower’s character refers to their willingness and ability to repay debts. Underwriters look at factors like:
-
Credit history – On-time payments of past debts indicate financial responsibility. Late payments or collections suggest higher risk.
-
Employment history – Job stability and continuity demonstrate reliability. Frequent job changes may be a red flag.
-
Residence history – Long tenure at the same address implies stability. Frequent moves raise questions.
-
Credit age – A longer credit history is preferred to a short one.
-
Inquiries – Numerous recent inquiries can signify credit hungriness.
-
Public records – Bankruptcies, judgments, and tax liens are seen negatively.
-
Debt-to-income ratio (DTI) – Lower DTI indicates ability to manage debts. High DTI is concerning.
-
Types of credit – A mix of installment loans and revolving accounts is ideal.
In short, character speaks to the applicant’s trustworthiness and commitment to meeting financial obligations.
Capacity
Capacity analyzes the borrower’s current financial situation and ability to take on additional debt. Underwriters investigate:
-
Income – Salary, wages, bonuses, commissions, and other sources of income. Underwriters require documentation like pay stubs, W-2s, and tax returns. Self-employed borrowers provide business tax returns and financial statements.
-
Fixed obligations – Housing expense, loan payments, child support, alimony, student loans, and other debts with regular monthly payments.
-
Variable expenses – Utilities, groceries, gas, clothing, entertainment and other flexible spending.
-
Assets – Checking and savings account balances, investments, and other liquid reserves. Assets can compensate for lower income.
-
Liabilities – Mortgages, installment debts, revolving balances, leases, and other obligations. More liabilities mean higher risk.
-
DTI – Compares total monthly debt payments to gross monthly income. Most lenders cap DTI around 50%.
Together, these factors demonstrate if the borrower can realistically afford the new monthly payment while managing existing commitments.
Capital
Capital refers to the borrower’s “skin in the game” – their down payment or equity contribution. Underwriters examine:
-
Down payment amount – Larger down payments signify lower risk as the borrower has more cash invested upfront.
-
Down payment sources – Underwriters verify funds are from the borrower’s own accounts, not borrowed. Gifts and grants may be allowed with documentation.
-
Equity – For home equity loans or lines of credit, equity cushions the lender if they must foreclose.
-
Collateral – Assets pledged as collateral also offset risk. Homes, cars, and business equipment are common collateral.
-
LTV ratios – Compares loan amount to collateral value. Lower LTV means less risk for lenders.
Capital demonstrates the borrower’s commitment to the loan. Borrowers with more capital contributed are viewed favorably.
How Underwriters Evaluate the 3 C’s
Underwriters don’t simply check boxes against the 3 C’s. They dig deeper by:
-
Obtaining documentation – Pay stubs, tax returns, and bank statements must support the borrower’s claims.
-
Verifying information – Employment, income sources, property values, and credit reports are confirmed.
-
Analyzing trends – Underwriters look at factors over time rather than a snapshot. Are things improving or deteriorating?
-
Evaluating compensating factors – One weak C can be offset by strengths in the other two. For example, a borrower with a short credit history but large down payment and solid income may still qualify.
-
Comparing to guidelines – Each loan program has underwriting guidelines that spell out acceptable risk thresholds. For instance, many mortgages require a minimum 620 credit score. Underwriters assess if the borrower fits within the particular program’s parameters.
-
Making exceptions – Within reason, underwriters can justify exceptions to guidelines when warranted by compensating factors. However, excessive exceptions create excessive risk.
Like detectives, underwriters piece together information from many sources to form the fullest picture of the applicant’s financial situation and loan qualification.
Tips for Borrowers on Successfully Passing Underwriting
As a borrower, the 3 C’s framework helps you put your best foot forward by:
-
Monitoring your credit – Review credit reports and scores from all three bureaus. Correct any errors. Pay down balances and dispute negative items if possible.
-
Holding off on new credit – Don’t apply for or open new credit accounts prior to your loan application. Too many inquiries and new accounts can raise red flags.
-
Maintaining positive payment patterns – Pay all debts on time each month leading up to your application. Delinquencies send up a red flag.
-
Documenting income completely – Provide all required pay stubs, tax returns, financial statements, and other documentation of stable income sources.
-
Minimizing liabilities – Consider paying off installment loans and credit cards with small balances. Close unused card accounts.
-
Beefing up your down payment – Sock away money for a larger down payment to hit key LTV thresholds for the best rates and terms.
-
Avoiding actions that raise questions – Don’t change jobs, transfer assets, or make major purchases during the underwriting process.
Thorough preparation and knowing what underwriters look for in the 3 C’s can streamline the path to loan approval.
The 3 C’s Provide a Solid Foundation for Prudent Underwriting
Underwriting will always rely more on art than science. While automated underwriting systems have grown in sophistication, human oversight remains essential.
The 3 C’s have endured as a simple yet meaningful framework for assessing credit risk. Other variations like the 5 C’s of credit add in Conditions and Collateral for a more robust analysis.
Nonetheless, the principles embodied in Character, Capacity, and Capital provide underwriters a methodology grounded in common sense. When layered upon modern risk modeling and analytics, the 3 C’s anchor underwriting in its most basic purpose – only lending to qualified borrowers within acceptable risk parameters.
So while underwriting may seem mysterious from the outside, its core relies on the fundamental 3 C’s.
Alternate frameworks for credit risk analysis
The 3 Câs of credit may be a widely-used conceptual framework, but theyâre not without criticism or competitors. While some might dismiss the 3 Câs model as an oversimplification, others have tried to rectify it through their own modifications, adapting the model to better fit specific industries or more recent technological developments.
Relevance and improving underwriting and decisioning
âCharacterâ may sound quaint in an age of machine learning and predictive algorithms, but what those modern tools really aim to do is quantify character so it can be properly weighed within an underwriting model.
Modern credit platforms donât do away with measuring character; they optimize it. Through automation, credit underwriting can be streamlined by combining traditional character metrics with new and alternative data sets. This automation allows for a more efficient and comprehensive assessment of a borrowers creditworthiness, ensuring that character remains a key factor in the lending process.
Capacity refers to whether a person, company, or other organization is able to repay the debt they take out on the schedule set out in their lending agreement. Itâs a measurement of real-world cash flow put into the context of specific financial products.
Whereas measures of character focus on trustworthiness, measurements of capacity focus on the applicantâs balance of income and expenses. A person with a strong credit history on their consumer lending products still might not qualify for loans with large credit limits, like a small business loan, if theyâre unable to demonstrate the earnings that would be necessary to repay the debt.
Several considerations factor into a typical measurement of capacity:
- Income and expenses. Whether considering a businessâs net revenue or an individual consumerâs income and expenses, most lenders donât have the risk tolerance for any entity without steady and predictable financials.
- Pre-existing debt. Credit providers may be more sensitive to an applicantâs debt than to other expenses, particularly any debts that are secured with liens. Here, capacity overlaps with the third C, collateral, as credit providers assess the likely outcomes in the event that they are unable to repay their debts.
- Future capacity. Credit providers might also consider how a borrowerâs capacity might evolve over the course of the credit product. For example, a high school graduate might not have the income to pay for their student loans, but the loan enables them to earn a higher income through completing education and training. Similarly, new businesses may rely on credit for years until investments in their infrastructure and personnel begin to pay off. In both cases, credit providers may look at metrics like grades or previous business performance to estimate future repayment capacity.
The 3 C’s of Underwriting
FAQ
What are the 3 C’s of underwriting?
This important step in the process focuses on the three C’s of underwriting — credit, capacity and collateral.
What are the 3 C’s of surety underwriting?
Surety underwriting is a meticulous process that evaluates the risk associated with providing a guarantee for the performance of a contractual obligation, a surety bond. The foundation of the evaluation are the three fundamental pillars known as the 3 C’s of surety: character, capacity, and capital.
What are the three main elements of underwriting?
- Income. Income refers to both gross and net income. …
- Appraisal. Appraisals ensure the property or other purpose of the loan is worth the requested amount. …
- Credit score. …
- Assets.
What are the 3 C’s of finance?
Character, capital (or collateral), and capacity make up the three C’s of credit. Credit history, sufficient finances for repayment, and collateral are all factors in establishing credit. A person’s character is based on their ability to pay their bills on time, which includes their past payments.
What are the three C’s of mortgage underwriting?
The three C’s form the framework of mortgage underwriting. Credit, capacity, and collateral are all important considerations for a lender extending financing. Banks and lenders develop complex statistical models to aid loan approval decision making. The final decision rests with the mortgage underwriter.
What are the 4 C’s of underwriting?
The 4 C’s of Underwriting are – Capacity, Credit, Cash, and Collateral. Even if the guidelines and risk tolerances change, the core criteria will not. The analysis of comparing a borrower’s income to their proposed debt is called capacity. The borrower’s ability to repay the mortgage is considered here. Lenders look at two ratios.
What are the 5 C’s of underwriting?
Most of the risks and terms that underwriters consider fall under the five C’s of underwriting: credit, capacity, cashflow, collateral, and character. (This is also known in the UK as the three canons of credit – capacity, collateral, and character.)
What are the three C’s of surety underwriting?
The Surety industry uses the ‘three C’s of underwriting’ in determining the Principal’s qualifications: Character, Capacity, and Capital. Character: A surety underwriter would want to establish a bonding relationship with someone who has good character.
What is mortgage underwriting?
In simple terms, mortgage underwriting is the process of determining whether a borrower is a good risk for a mortgage loan. This decision is based on several factors, such as the borrower’s credit score, employment history, and debt-to-income ratio. Underwriting plays a crucial role in the mortgage process.
How does underwriting affect a mortgage?
Underwriting plays a crucial role in the mortgage process. It’s the underwriter’s job to ensure that the borrower can afford the mortgage payments and that the property being purchased is worth the loan amount. The underwriter’s decision can significantly influence whether the loan is approved or denied.