A lender's readiness towards trusting the borrower to pay their debts

Author: Arnav Chaudhary
Arnav Chaudhary
Arnav Chaudhary
Arnav Chaudhary is currently a CFA Level 2 Candidate who has expertise in financial modelling and data analysis. He has a baccalaureate in Economics and Mathematics from University Of Delhi.
Reviewed By: Rohan Arora
Rohan Arora
Rohan Arora
Investment Banking | Private Equity

Mr. Arora is an experienced private equity investment professional, with experience working across multiple markets. Rohan has a focus in particular on consumer and business services transactions and operational growth. Rohan has also worked at Evercore, where he also spent time in private equity advisory.

Rohan holds a BA (Hons., Scholar) in Economics and Management from Oxford University.

Last Updated:February 6, 2024

What Is Creditworthiness?

The lender determines an individual's creditworthiness or the credibility to pay the loan based on various factors such as the amount of liability one has, the number of assets, credit score, or any history of failing to repay the EMI.

The lender looks at it before giving the loan to the borrower. A borrower can not determine their creditworthiness as it will result in a conflict of interest such that certain intermediaries are appointed to look out for the evaluation process.

In simple words, it is the opinion of the lender on the borrower, whether that individual can pay their debt obligations or not if a borrower is considered to be credible to pay the loan if and only if they deemed to pass the confident creditworthiness assessment.

If a creditor thinks of the individual as a risky borrower, the required amount of loan might not get sanctioned to that person or an entity, or a higher rate of interest might be imposed, or as in comparison to the desired loan amount, a lower amount of loan might get offered.

Key Takeaways

  • Creditworthiness is what the lender looks into the customer before availing up the credit.
  • Down Payment on the loan, credit reports, and collateral all help with the evaluation of the creditworthiness of the customer.
  • Big Data, references from other lenders, regional risks, and financial standings can help evaluate it for new customers.
  • Credit Checks are also done by landlords, prospective employers, utility companies, etc.

Understanding Creditworthiness

In simpler terms, it defines how suitable that person is for that loan. Individuals' creditworthiness is determined by their credit scores or how they have dealt with credit in the past.

A good credit score range might depend on a particular credit model. Generally, credit scores from 560 to 669 are considered fair, 670 to 739 are considered good, 740 to 799 are considered very well, and scores above 799 are considered excellent.

It is beneficial to be creditworthy in the long run as it only helps in financing a personal loan but also helps in receiving better interest rates, better terms and conditions on a credit card or loan, and fewer fees.

It also acts as a factor in getting employment, certifications, licenses, or the credibility to obtain funding for the business.

Lenders depend upon third-party rating agencies to evaluate their creditworthiness. Therefore, the information related to the borrower's credit may be manipulated in the market so that these credit rating agencies determine them independently.

Generally, the lending agencies pay for the services to the credit agencies, but borrowers also ask for their assistance to gauge their credit scores.

Factors Affecting Creditworthiness

Generally, lenders have their terms and conditions for evaluating creditworthiness, such that it is essential to look out for lenders who may lend according to the needs, but there are certain factors that lenders look out for:

1. Income or Debt 

To repay the loan, an individual must have an appropriate amount of revenue because, on top of living expenses, a certain amount must be appropriated to pay the installments on the loan.

  • Lenders use the data related to income to calculate the Debt Income Ratio (DTI). DTI tells how much of a person's monthly payment is covered by debt obligations.
  • Lenders generally accept a DTI ratio of up to 36% but, in some cases, may receive up to 50% of the income. The lower the DTI ratio, the better it is to obtain a loan.
  • For Eg- A person with a monthly income of $10,000 has a monthly debt of $3000, then his\her DTI would be 30%.

2. Credit Score 

A credit Score is a desirable factor in obtaining a loan; the higher the credit score, the more beneficial it is. To have good credit, specific tips have to be kept in mind.

  • Pay Installments on time.
  • Keep the amount of debt low.
  • Keep the oldest credit cards to establish an ancient credit history.
  • Do not take new debt if not necessary.

3. Collateral

Something of value must be kept as collateral on securing the loan as in the circumstances of failing to repay the loan. A car, house, or anything of value can act as collateral.

4. Down Payment

Down Payment is the amount a borrower pays on a large purchase of something like a car, house, or any item of value. 

The more significant the amount of the down payment, the more will be the borrower's possession, and a lesser amount might be needed on the loan.

It is good to have a savings plan such that small amounts can be appropriated into a savings account to afford something desirable in the future.

5. Co-Signers

It is constructive to have a co-signer along as a co-signer agrees to repay the loan if the borrower defaults on the loan amount. A lender also evaluates their creditworthiness as it helps obtain more loan amounts.

Creditworthiness – Credit Scores for Individuals

A debtor can use the several tools mentioned below to measure the creditworthiness of a new customer:

1. Using Big Data 

The more voluminous a customer's database is, the better it will be to access the consumer's information. However, with being more voluminous comes a more complex problem of processing that volume of data.

Big Data helps in analyzing data with a lot of bulkiness. In today's time, technology like big data is helping companies' credit departments improve efficiency.

2. References  

Before extending the loan to the customer, a company asks for some references from whom the customer may have availed credit in the past.

For Eg- Banks may have lent credibility to the customer.

There is a very time-consuming process as it may take a lot of time to receive replies from the other party.

3. Financial Standings 

The business's financial reports must be checked with the appropriate financial ratios of the company so that it can be ensured whether or not the business might be able to pay back the loan.

Checking the company's cash flow statements might help prevent the efficiency of how a company is operating.

4. Regional Risks 

The geopolitical risks associated with the business the customer might be working in must be checked. Sometimes, the company's financial standings might make the company financially sound.

But significant risks associated with operating that business in a region where it might not flourish for long might not be a viable option to give a loan.

All these factors help determine the customer profile and help choose the risks associated with lending a loan to a particular customer. Therefore, customers should consider these factors as they may affect the loan process.

Good Creditworthiness Benefits

Other than acting as a factor of a loan being granted to a customer, a credit report can help in dealing with:

Landlords often run credit checks that help them in making decisions on whether they should give the property for rent or not.

Since a book can not be judged by its cover, the same is the thought process of landlords who like to protect their investments by checking up on the habits and financial stability of the tenant.

Auto Insurers check the credit report before insuring a vehicle you own. In short words, it can be said that vehicle insurance is also a line of credit where the insurers like to run these checks on how a customer manages their credit lines.

Utility companies often run credit checks before lending equipment or opening an account.

Like other credit companies, utility companies also check their customers' credit reports, where a good credit report can help with availing up of services, and a bad credit report will impact severely.

There is a prerequisite of running a check on credit reports which prospective employers do before hiring the desirable candidate.

The logic behind the employers evaluating the credit reports is that an employee with a bad credit report is not efficient with managing their finances, which might affect their work performance.

Creditworthiness – Credit Ratings for Securities

In 2008 several big rating agencies were criticized for failing to provide accurate ratings and reports on subprime mortgages, considered one of the biggest financial disasters in history that impacted countries and their individuals worldwide.

These companies failed to gather information according to the protocols defined, leading to the rating of bonds backed by these sub-prime mortgages at a very high rating considering many associated risk factors.

The federal reserve bailed out AIG (American International Group), and their credit ratings were dropped severely because of the backlash of the events of the 2008 financial crisis.

Because of the 2008 crisis, several top investment banks were bankrupted as the federal reserve refused to bail them out as well as several other banks were on the brink of bankruptcy as they were bleeding money.

These ratings are not given to individuals but also to short-term and long-term debt obligations.

Researched and authored by Arnav Chaudhary | Linkedin

Reviewed and edited by Aditya Salunke I LinkedIn

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