The Five C's of Credit: Capital
I recently started a new series for our Pinch Blog focused on helping you understand the mortgage application process and the best way to set yourself up to be approved. I started talking about the 5 C’s of your financial picture and started with financial character. Today I want to talk about capital, the second C.
Few people use the word capital in everyday discussions about their savings because they assume you need to have a lot of money to call it capital. Capital is simply the term used by bankers to understand the total sum of your assets and net worth. For example, if you have equity in a property, and you are considering selling that property to purchase another, then that equity is considered part of your capital.
Savings and investments
In addition to equity in a property, your capital can also include any cash savings and investments. While the amount of capital you have is important to qualify for a mortgage, the type of capital you have will also matter. It is relatively simple for your banker to appraise the value of your property, but capital from investments can be more difficult.
Depending on how you choose to invest your money (cash, GIC, mutual funds, equities, etc.) there can be variation in value and risk. For this reason, each of these investments is treated differently by each bank when it comes to valuation. Make sure you ask your banker up front if they are using the full value of your investments, or an equation that is meant to determine a conservative estimate of the value.
Typically, if you are purchasing a property within the next year your savings should be in either a savings account or a GIC as you do not have a long enough time horizon to be more aggressive. Some advisors will push you to go with a mutual fund that invests in bonds, but be aware of the management fees and potential penalties for early withdrawal.
Another aspect of the capital conversation will be net worth. You will often read news articles about the net worth of celebrities or business tycoons in Forbes magazine, but every one of us has a net worth. Determining your net worth is simple, add up all of your capital and then subtract all of your debts (loans, credit cards, mortgages, lines of credit, etc.).
The general rule of thumb is that your net worth will grow as you age, reaching its peak in your mid 60s, and then will begin to shrink again as you draw down from your investments in retirement. In addition to showing good habits, having a positive net worth is a good sign for banks as it means you will have access to capital in the event of an unforeseen circumstance, such as going on leave from work.
Many home buyers get hung up on the amount they will have for a down payment, but do not give enough thought to where those funds are coming from and how they fit into their larger financial picture. If you have saved a lot of money for a down payment by carrying debt rather than repaying it, then you may not be any further ahead.
A combination of repaying your debts and building your savings will not only show good financial character, it will also help you build your net worth and make banks more comfortable approving you.