Creditworthiness is a measure used to determine if a borrower should receive credit. If the lender is confident that the borrower will pay off debt on time, they are deemed creditworthy.
Lenders aren’t the only people interested in your creditworthiness; suppliers and customers also use this factor to assess a company’s financial reputation.
Nobody wants to buy or supply goods to a company with a reputation of not paying off debt. If you’re one of those companies, all’s not lost; you can still improve your credit rating. Here’s more about the subject.
What is Creditworthiness?
It evaluates one’s ability to repay debt. Apart from savings, lending institutions base their business models on borrowers’ ability to repay their debt obligations. As such, they must minimize the risks associated with lending cash.
What Factors Determine Creditworthiness?
Creditworthiness is a function of many factors. Here’s a summary:
Reviewing Your Credit Report
The credit report is a compilation of your credit history collected from all your bank accounts and is usually issued by a credit bureau. The information is available to creditors for seven years for a normal credit application.
However, if you have filed for bankruptcy before, that information remains on your credit report for 7-10 years. When a lender requests a credit report from a credit bureau, they’ll find the following information:
- Basic personal profile data except for your telephone number and contact address
- Total outstanding balances
- Aggregated credit limits
- A record of the credit checks made on your accounts
- Closed credit accounts. If they’re older than 3 years from the date the account was closed, they might not appear on the report
- Bankruptcy records. However, if you’ve paid for the debt in full, the bankruptcy order is annulled, and the record removed immediately
- Credit repayment history for the last year including late payments on credit card bills
Checking Your Credit Score
A credit score is a measure of your financial ability and shows how likely you’re to pay debt. It also helps banks and other lenders to determine the interest rates charged on loans and credit cards.
The borrower is assigned a number within a range of 300-850. High numbers depict a good credit score and those below 640 are considered subprime borrowers hence charged high interest rates. The bank may also require such borrowers to provide a co-signer or apply for a short-term loan.
Conversely, borrowers with credit scores of 700 and above are considered low-risk borrowers. As such, they enjoy low-interest rates and longer loan terms. Typically credit scores are based on a range of factors:
The Applicant’s Payment History:
It accounts for 35% of the credit score and shows if the borrower pays their debt obligations on time. As such, payment issues like tax liens, charge-offs, bankruptcy, or foreclosure can affect your credit score.
The Debt Level:
It makes up 30% of your credit score. It accounts for the amount of debt, the ratio of credit balances to credit limit (credit utilization), and the loan balances in relation to the original amount.
Credit History Period:
It makes up to 15% of the total score and is a function of two factors. The age of your oldest account and the average age for all your accounts. The older the account, the better the credit score because it indicates you have lots of experience handling credit.
Type of Credit Account:
Generally, there are two types of credit accounts: installment loans and revolving accounts. Borrowers with the two accounts show they have more experience managing different types of credit; moreso if they have loans for assets like cars or homes.
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Verifying Your Income and Debt
While the borrower’s income, debt, and credit score are closely related, lenders evaluate them separately. This is because people with high incomes may have a low FICO score and vice versa.
In addition, lenders use the FICO score when giving auto and home loans only. If applying for other types of loans, your income plays a critical role because lenders want to know you can afford to repay the loan. They usually calculate the debt-to-income ratio to compare your income to debt payments. A ratio below 43% looks good on your report.
Documenting Additional Assets
If you have already retired and are applying for a loan, lenders will consider any additional assets you have. They may ask if you have real estate property, savings, a steady income, investments, and other financial assets to prove you have the resources you can use to repay the loan.
What is Credit Rating and How it is Measured?
Lenders use credit ratings to determine if an applicant is eligible for credit. Also known as a credit score (explained above), it is a qualified assessment of a borrower’s credit worthiness with respect to their financial obligations.
Credit bureaus like Equifax, Experian, and TransUnion assign individual credit ratings. It’s usually a three-digit number. For companies and governments, credit ratings are assessed by credit agencies like Fitch Ratings or S&P Global.
Why Does My CreditWorthiness Matter?
Having explained all the factors that affect a borrower’s creditworthiness, it’s essential to understand its importance. The creditworthiness definition denotes that it determines a borrower’s ability to pay. If a borrower can repay a loan, the lender will likely advance low-interest loans with a higher credit limit.
What Does a Bad Credit Card Mean?
Unfortunately, not everybody is creditworthy. Some borrowers have histories of failing to pay bills on time and defaulting on loan payments. This is referred to as having bad credit and is often reflected by a low credit score (less than 580).
When a borrower has a bad credit history, it’s difficult for them to get credit card debt, let alone having their loan applications approved. However, the borrower can still apply for credit referred to as bad credit. They have two options:
- Apply for a secured card: In this case, the borrower must put down a security deposit equal to the line of credit they want
- Apply for an unsecured credit card
Alternatively, the borrower should consider improving their credit score by:
- Paying down credit card debt: The borrower can pay small payments whenever possible to reduce the debt. It would help if they set realistic repayment goals and work toward it gradually
- Keeping unused credit card accounts open: You don’t want to accumulate more debt by opening new credit card accounts. Also, it doesn’t mean you should close unused credit card accounts. Keep in mind the credit use this metric when assessing your credit score
- Setting up automatic payments: The idea is to help ensure you pay a minimum amount every month
- Check interest rate disclosures: The premise is to identify credit card debt with high-interest rates and pay them off fast
Frequently Asked Questions (FAQs)
How do you determine creditworthiness?
If examining an individual’s creditworthiness, the lender checks:
- The credit report
- FICO score
- Income and debt level
- Additional assets they may have
- The company’s financial health: The lender examines the company’s financial statements to learn about its performance
- References: The lender also requests trade references like the company’s suppliers
- The regional inherent risk: Businesses face inherent risks based on their geographical location. For example, currency exchange rates pose a unique risk to a business in the export and import business applying for a loan
What are examples of creditworthiness?
An individual’s creditworthiness determines the interest rate charged and even the amount secured as a loan.
If John has a credit score of 800, he is more creditworthy. Thus, if he applies for a loan of $6000, the bank will approve it at the current interest rate, say 11%. However, if his friend Loius has a credit score of 490 applies for a loan of $3000, a higher interest rate is charged, say 23%. Louis pays a higher interest because he is less creditworthy.
However, if John’s debt-to-income ratio is more than 43%, he is less likely to get a large loan amount. The lender may cap the amount to $4000 or less.
What are the 3 C’s of creditworthiness?
This is a method banks use to establish if you qualify for a loan. They look at three factors: Character, capacity, and character (discussed below).
Is Creditworthiness and Trustworthiness the same?
No, they’re not. Trustworthiness is a subset of creditworthiness as it examines the borrower’s character. This means looking at his credit history, credit score, report, and other such features.
What are the 5 C’s of credit?
A well-known formula for determining a borrower’s creditworthiness is the 5C’s of credit:
- Capacity: It is the borrower’s or company’s financial capacity to repay a loan. The lender calculates the debt-to-income ratio to determine if they have adequate cash flow
- Capital: These are financial and non-financial assets and the amount of money the borrower has
- Character: The applicant’s credit history reflects this metric. It indicates if the applicant is willing to repay debt
- Collateral: These are assets a bank can use as security for the loan
- Conditions: Lenders also examine other factors that may affect the borrower’s ability to repay. They include prevailing interest rates, the amount involved, the purpose of the loan, and the applicant’s industry