Accessing Your Credit - How Do Lenders Make Their Decision?
, by Rob Kaufman
As borrowers, most of us know that we have a FICO® Score and that our score represents our creditworthiness. The factors that make up a credit score are a big part of how lenders see how our background and past performance regarding the handling of our finances. However... there's more.
From a lender's standpoint, they need to weigh specific characteristics of the borrower and the conditions of the loan as a way to gauge the chance of default and the potential of financial loss. For this reason, they've developed the "5 Cs" of Credit.
The 5 Cs of Credit
Lenders use both qualitative and quantitative measurements to evaluate a lender's creditworthiness. Sure, they look at credit reports, credit scores, income statements, tax documents and more, but they also take into account information about the loan itself.
This refers to your (the borrower's) track record of repaying debt. This information is found on your credit report from one or all three of the credit reporting agencies. These reports not only display your "payback performance", but also contain information about collection accounts and bankruptcies. Once they compile all the information about your "character", they're one-fifth of the way toward making their decision.
What's your debt-to-income ratio or DTI? (Total monthly debt payments divided by your gross monthly income.) The lower your DTI the better your chance of qualifying for a new loan. Most lenders prefer an applicant's DTI to be around 35% or less. For mortgages, most lenders are prohibited from issuing loans to applicants with a DTI of 43% or lower. What's your DTI?
What amount of assets can you put toward your investment or loan? For example, can you put a down payment on a mortgage or auto loan? The larger the capital contribution, the less chance of default and the greater opportunity for a lender to accept your application. The size of your down payment can also affect your interest rates and terms - for the better. So think about waiting to accumulate more money for a larger down payment before purchasing that home. It could end up saving you a lot of money down the line.
According to Investopedia: Collateral is a property or other asset that a borrower offers as a way for a lender to secure a loan. If the borrower stops making the promised loan payments, the lender can seize the collateral to recoup its losses. That's why having collateral can help borrowers get approved for loans - lenders can feel more assured that if you default on the loan, they can retrieve the collateral (property or other assets).
When referencing the "5 Cs", Conditions refers to the conditions of the loan - i.e. the interest rate and principal amount. Oftentimes, the lender takes into consideration the purpose of the loan. For instance, a home improvement loan or HELOC might be more likely to get approved because there's a specific purpose to the loan, unlike a signature loan which could be used for just about anything. Conditions might also include the state of the economy, industry trends or pending legislative changes - all things out of your control, but still part of the fifth "C".
Take a look at myFICO forums and check out how other members have handled the application process... and if they had their "5 Cs" in order.