Have you ever wondered how banks or other finance companies decide whether to lend you money? It’s through checking your creditworthiness.
Creditworthiness refers to how deserving you are of receiving new credit. Your creditworthiness is typically determined by the lender or the person you are borrowing from. Ultimately, your creditworthiness can determine whether you are eligible for a particular kind of credit and how much interest you pay.
It is vital to understand the term “information asymmetry.” This term simply means that, in some situations, one party might have more information than the other, which results in an asymmetry of information.
Example of Creditworthiness
For example, in the credit market, the lender won’t know a borrower’s personal information, history with credit, and ability to pay back. This puts the lenders at an information disadvantage if the borrowers do not reveal this information.
The lenders are primarily concerned with a risk of default – a situation wherein the borrower is unable to pay back the borrowed money, either in the form of an interest or principal payment.
This inherent information asymmetry between two parties and the risk of default is why financial intermediaries perform the impartial task of determining a borrower’s creditworthiness. It allows lenders to access information that was previously unavailable to them.
Almost any kind of borrowing requires an assessment of your credit score and/or your credit report, which depend on numerous underlying factors. A creditworthy individual can be broadly defined as someone with no risk of default – someone who will pay back their debts as agreed upon by the lender and the borrower.
Why Does Creditworthiness Matter?
Credit impacts everything from buying a phone on EMI to purchasing your first home or taking out a loan for an emergency. Because creditworthiness is a metric that determines whether you have access to credit, it can have serious repercussions on your living.
Moreover, your credit also determines the cost of borrowing – the interest rate. Creditworthiness can be a strong determinant of the rate you will pay on your borrowed amount.
In the case of a long-term loan, such as a mortgage, even tiny increases in interest rates can cause a massive increase in the overall amount you pay. Additionally, poor credit history might reduce the amount you are given as a loan.
In conclusion, creditworthiness is crucial for two reasons – it can determine your ability to qualify for any kind of credit, and if you do, determine the conditions.
How is Creditworthiness Measured?
The process of determining an individual’s creditworthiness has become relatively standardized. Most lenders view your credit reports or credit scores to assess your worthiness of receiving credit.
However, the underlying factors that determine your credit report or score can change depending on why you are borrowing. From our discussion on information asymmetry earlier, credit scores and reports are efficient mechanisms that bridge the information gap between lenders and borrowers.
A credit report aggregates your history of managing credit and repaying your debts. Based on your credit history and how well you have managed credit in the past, lenders can get the necessary information to determine your creditworthiness.
All the data on your credit report, but especially your payment history and credit utilization, can have serious repercussions on how credit-worthy you are. The detailed information on your credit report ultimately decides your credit score.
Understanding your credit report is crucial as it allows you to know which areas need improvement to increase your creditworthiness.
What Does The Credit Report Include?
While most credit reports include similar information, they might just be presented in a different manner. For example, an Experian report contains the following items discussed below:
The first piece of information that any credit report has is your personal information. This includes your full name, variations in names you might have had while applying for credit, addresses, names of your employers, and individuals with whom you have jointly applied for credit. This information does not have too much direct impact on your creditworthiness; rather, it is a way of verifying your identity.
Second is the list of accounts you have. It lists all your open loan and credit card accounts, including your payment history for each type of account. The report mentions if each of these payments was on time or not.
Closed accounts are also mentioned on your report for typically ten years after they are closed. History of foreclosures, repossessions, and accounts turned over to collections are also mentioned here, which can have a severe negative impact on your creditworthiness.
Third, your credit report mentions inquiries – a lender’s request to view your credit report or score. A hard inquiry is when your credit report/score is requested for a new credit application, whereas a soft inquiry is when you or a lender are already engaged with requests to view your credit report.
Lastly, there might be a public records section on your report if you have filed for bankruptcy in the past, which usually stays on your report for seven to ten years. Needless to say, bankruptcy can jeopardize your creditworthiness.
A credit score condenses all the information from your credit history into a numerical rating. It usually ranges from 300 to 850, with higher values indicating a better credit score. There are two major score ranges, the FICO score range, and the VantageScore range. A good credit score ranges from 670-739 in the FICO range and 661-780 for the Vantage score range.
While the exact number range differs between each model, the underlying factors that determine your credit scores are similar. Moreover, different weightage can be given to different factors depending on the model used and the purpose of the score. For example, FICO has a base and industry-specific scores for credit cards and auto loans.
The recorded history of timely payments and successful management of various credit sources can have a strong positive impact on your credit score. On the other hand, late or no payments and bankruptcies can adversely affect your score. A low credit score can make having access to credit difficult and increase the cost of borrowing.
Factors That Determine Your Credit Score
Payment history has a 35% weightage in determining your credit score on the FICO score. Next, credit utilization accounts for 30% of your credit score. Your credit utilization rate, which applies to only revolving lines of credit such as credit cards, measures what percentage of available credit you use.
You may want to demonstrate a low to moderate reliance on credit to show responsible borrowing and a lack of reliance on credit to fund your lifestyle. A rate below 30%, or using less than 30% of your available credit, is considered ideal.
The third factor is the length of your credit history. Having a longer credit history, i.e., the average age of all your credit accounts, is considered favorable. This implies that it takes consistency and time to build a good credit score.
Lastly, your credit mix accounts for 10% of your score. Credit mix refers to the various sources of credit you have – credit card accounts, various loans, and mortgages. Having a strong credit mix highlights your ability to successfully manage multiple credit sources, thus potentially improving your credit score.
Other Factors Lenders Look At to Determine Creditworthiness
While credit scores and reports are standard items to consider, a lender may further look at various parameters that better illustrate your personal context.
Debt to Income Ratio
Sometimes lenders use custom credit rating models that best suit their purpose. For example, a creditor might consider a debt-to-income ratio (DTI) in order to determine how much extra debt you can afford to take. DTI measures your debt as a fraction of your income over a period of time.
If you already have a high amount of pre-existing debt, such as credit card debt, student loans, and other loans, your DTI ratio will be high because your existing debt obligations claim a large percentage of your available income. Hence, a high DTI indicates your inability to take on more debt, reducing your creditworthiness in the eyes of the lender.
To adjust your DTI, you can either increase your income or decrease your debt. While increasing your income might be a difficult task, unless you decide to take a better job or add a side hustle, getting rid of your debt might be more achievable.
Making temporary changes in your lifestyle to pay back more of your past dues is a viable method to clear your debts. This can improve your DTI ratio and, consequently, your creditworthiness.
Certain types of loans – such as home loans and car loans – need to be secured with an underlying asset – your home and car, respectively. This again goes back to the information asymmetry problem – in order to protect themselves from the risk of default, the lender expects an asset that can be repossessed in case you are unable to repay.
Secured loans can typically make you more creditworthy and improve the terms on which you get the loan. Even if there is no underlying asset, such as a car or a home, you can use other items as collateral. For example, in the case of student or personal loans, you can use a certificate of deposits (CD) and savings accounts, amongst other things, to collateralize your loan.
When you make a large purchase, such as a property or a car, a down payment is an amount you pay upfront. To own the asset, this is a partial amount that you pay and borrow the rest from a lender. A higher down payment indicates that you have a higher stake in the asset and need to borrow less.
This can increase your creditworthiness as your risk of default is lower. Having a large amount as a down payment can give you more options in terms of selecting your lender and also decrease the rate of interest on the loan.
A larger down payment might also save you the cost of insuring the loan. For example, in the case of housing loans, if your down payment is higher than 20% of the house price, you do not need to opt for private mortgage insurance.
The best method for a large down payment is to start saving early and take out a loan only when you have saved a substantial amount.
The Bottom Line
You might want to think of your creditworthiness as dynamic, as opposed to static. Credit is an integral part of life, and every decision you make can have repercussions on your credit scores. Credit tracking is quite rigorous, as demonstrated by credit reports, which have extremely minute details about your credit history.
By practicing consistent and responsible credit management, you may be able to maintain a high credit score and creditworthiness.
However, always remember that precisely because your credit score is dynamic, there is always scope for improvement. Over long periods of time, you can correct even large credit mismanagements, which can improve your future borrowing prospects. Make sure you understand what factors have the highest weightage in determining your credit scores and prioritize accordingly.
VITAL Card blog posts are intended for informational purposes only and should not be considered financial or any other type of advice.