December 06, 2022
Bitcoin and the Five C's: Capacity
The main thesis of this series is that Bitcoin fundamentally transforms a lender’s ability to properly evaluate risk. In order to explore this claim further, these articles unpack the most common factors used by lenders to assess the risk profile of a potential borrower known as The Five C’s: Credit, Capacity, Capital, Collateral and Conditions.
Now that credit reports, FICO scores and CRA’s are better understood after the first article, this post pays attention to Capacity.
Capacity refers to a borrower demonstrating their ability to repay or service a new debt obligation. The first two dictionary definitions for the word are relevant for describing what lenders are looking at with this “C”.
(1) the maximum amount that something can contain.: "the capacity of the freezer is 1.1 cubic feet" "the stadium's seating capacity""the room was filled to capacity".
How much debt can a single consumer handle before they are “filled to capacity” and drowning with liabilities? Lenders want to know.
- A borrower must demonstrate a clear ability to repay or service the new loan payment they are applying for by documenting their debt-to-income ratio.
- A borrower with too many existing obligations without an acceptable level of relative income, is considered higher risk to a lender.
The official credit report provides lenders with a clear understanding of a borrower’s existing obligations. Not just the amount they owe in total, but also the minimum monthly payment they are required to make across all of their liabilities. Not all liabilities are created equal in the eyes of a lender when evaluating the prospects of issuing additional debt.
The most common and highest risk type of liability is known as unsecured revolving debt. Any form of debt that allows you to continuously re-borrow against a set credit limit is considered revolving. Credit cards and personal lines of credit are forms of debt which provide on-going buying power to a borrower without the need for collateral. As long as the borrower doesn’t exceed the set limit through periodic payments, the line of credit continues to ‘revolve’. The tradeoff for the high risk that lenders take in extending this type of credit is much higher interest rates than other types of debt.
The opposite of unsecured revolving debt is fixed term secured debt. All possible configurations of secured/unsecured and fixed term/revolving debt exist.
To offer some more examples:
- Student Loan: unsecured fixed term liability. There is no hard collateral, only the promise of an education, which presumably increases a borrower’s likelihood of producing income. There is also no ability to re-borrow as the loan is paid down.
- Auto Loan: secured, fixed term liability. These loans are secured by the vehicle itself serving as collateral. As the loan is paid down, there is no option to re-borrow.
- Home Equity Line of Credit (HELOC): secured, revolving liability. The home is the collateral, but the total line of credit that has been extended can be continuously re-borrowed against as its paid down.
Regardless of the configuration, when evaluating this aspect of a borrower’s capacity, a lender looks at the minimum monthly payment required on every obligation and adds them up to determine the first aspect of the borrower’s Debt-to-Income Ratio (DTI).
Whatever the number reported on a borrower’s credit report as the minimum monthly payment, is the amount that is counted against the borrower’s existing liabilities in their DTI calculation. The only exception is that a fixed term liability scheduled to end in less than 10 months can be excluded from the borrower’s debt.
The second definition of capacity helps illuminate the second half of DTI: "the amount that something can produce; the company aimed to double its electricity-generating capacity" "when running at full capacity, the factory will employ 450 people"."
What is this borrower’s track record of producing income and how much income are they likely to continue to produce before they reach their income capacity? Lenders want to know.
Evaluating a borrower’s income is a much different exercise than calculating their monthly debt obligations. How much income a prospective borrower is producing isn’t simplified in a FICO score, rather it’s determined by their current income, and at minimum, the past 2 years of earnings.
Lenders typically want to see that a borrower has stability, consistency and predictability in their income streams.
- A borrower who has a stable (2+ years) W-2 job is the most straightforward calculation for determining the “I” in DTI.
- If John Doe has earned $100,000/year for the past 2 years in the same position at ACME Inc, the lender will use the gross monthly amount of $8,333 in their debt to income calculation.
- If there are less than 2 years of consistent income, or if the type of income is less stable than a W-2 base salary (i.e. Bonus, Self-Employed, Commission, etc) other documentation will be required before a lender will consider the income towards a borrower’s qualifying income.
Imagine that the total amount of monthly debt obligations on John Doe’s credit report are $943/month. The DTI ratio would be 11% (943/8333). Lenders then add the proposed amount of the new liability to determine the total DTI assuming the new loan is approved.
If John Doe is applying for a mortgage that will come with a total monthly payment of $2500. The DTI calculation is 943+2500=3443. The total amount of monthly payments is then divided by total qualifying income or 3443/8333 and the DTI ratio ends up at 41%. A healthy DTI is under 43% but you can typically get approved as long as your total DTI is under 50%.
Measuring a borrower’s existing liabilities against their predicted income offers lenders insight into the level of risk they are taking by extending financing. Of course the biggest limitation here is that past performance and current realities do not necessarily predict future outcomes.
A borrower’s W2 may show $100,000 income, for the previous year, but that doesn't guarantee the borrower will still be employed after the loan is consummated. Also, while credit reports provide a clear picture into the vast majority of a borrower’s debts, there are many types of liabilities that are not reported to the Credit Bureaus and therefore not able to be counted in a borrower’s DTI.
In a bitcoin standard, lenders could conceivably look at a borrower’s bitcoin holdings and measure the growth of their savings over time, the duration that sats are held without moving and the quality of a borrower’s custody model as factors for determining their capacity. These potential advantages begin to blur the lines between the traditional 5 C’s as bitcoin shatters the existing creditworthiness paradigm. Perhaps the most relevant and comparable C to examine is Capital, which is studied in the next part of this series.
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