Financial Planning | Personal Finance | Article
Are You Financially Creditworthy For A Loan
by The Simple Sum | 24 Sep 2024
When you apply for loans or credit facilities, banks always ask you for a list of information to screen your financial health. They use a systematic stringent method called the “5Cs” assessment (capacity, character, collateral, capital and conditions) to evaluate how financially worthy you are for them to lend money to.
Based on the 5Cs assessment, banks then assign you a credit rating which suggests what type of borrower you are. The higher your credit rating, the lower your credit risk which means the lower the probability of you defaulting on the loan.
What is the reason for 5Cs
In the bank’s lending business, a borrower’s credit risk is the key consideration in whether to approve a loan because if the borrower cannot pay back the loan, the bank has to write off the loan and take it as a business loss.
So, if your credit rating is low, the likelihood of you not paying back the bank is high. They are likely to reject your loan application or offer you a smaller loan amount with a higher interest rate. However, banks also reward high credit-rated borrowers with better loan terms and lower interest rates.
The 5Cs of borrowers’ financial creditworthiness
At some point along your financial journey, you would need to take up a loan out of necessity; for example, to finance big item purchases such as a house, car or investment property. So that you qualify for loans and at the best terms and rates, you have to supercharge your 5Cs to score top marks in the evaluation.
| Here are the 5Cs criteria explained: –
Capacity – How much income and debts do you have? The first C measures the borrower’s ability to repay a loan. Banks use the debt-to-income ratio to figure out if you can pay your loan. If you have a lot of debts in proportion to your income, banks probably won’t approve your loan. Character and credit history – Will you repay your loan? Also known as credit history, the second C refers to the borrower’s reputation and track record for repaying debts. Banks want to know if you are a responsible, stable and trustworthy person to lend money to. They will look at your track record in managing your credit and making repayments which are reflected in your credit score report issued by the credit bureau. Collateral – What assets do you have to secure the loan? Banks also consider if you have any personal assets you can pledge as collateral to support the loan application. It is a backup in case you lose your source of income and cannot repay your loan. Capital – What are your assets? Down payments for purchases show the borrower’s seriousness and commitment to the purchase. Banks will be more comfortable extending credit. Conditions – the general conditions relating to the loan This is a general assessment of conditions relating to the loan. Banks will assess what you intend to do with the loan and rationalise if it makes sense to lend money to you for your intended purpose. For example, if you want to borrow to buy an expensive property and your job is not secure because you have just started work in an industry with a high retrenchment rate. These are not favourable conditions for a big loan because you are at risk of losing your job. |
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Why is your financial creditworthiness important?
A high creditworthiness rating means you are financially trustworthy and responsible
If you are on top of all the five criteria, you are rated as a highly creditworthy borrower. It means that you are a low credit risk borrower who can pay your loan on time. The banks also don’t need to worry if you lose your source of income because you have assets that can be used to pay back part of the loan.
Because of your low credit risk to the bank, highly-rated creditworthy borrowers are often rewarded with more favourable loan terms, like lower interest rates.
A low creditworthiness rating means the bank faces the risk of you not paying back the loan
But if you fare poorly in the evaluation, the bank will be very cautious in lending to you because they face a higher risk that you may not pay back the loan.
Most times, lower-creditworthy borrowers find it difficult to get a loan; even if they do, it will be a smaller amount. They also often impose more stringent loan terms and charge a higher interest rate for the loan.
How to pass the financial 5Cs with flying colours
Being highly financially creditworthy is vital in your financial journey because there are times when you need to use loans to help you build wealth and achieve your financial goals. For example, if you want to invest in a home or decide to further your studies, loans come in handy to reach these goals. For this reason, you must be sure that you are financially creditworthy for banks to consider you a premium borrower who can borrow at any time and at the best rates and terms. Here are some simple steps that you can take to pass the evaluation with flying colours.
| Polish up a sparkly clean credit character
Banks pay a lot of attention to your credit history and character in dealing with loans. They love a responsible person who uses credit responsibly and pays their credit card bills and loans promptly. So, if you have earned yourself good credit scores, you are the idle candidate for more borrowings. If you have a scratched report, here are things you can do to clean up your credit image.
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| Maintain a good debt-to-income ratio, and think twice before taking up loans and using credit
Banks don’t like to see high debt-to-income ratios because it suggests that you are a dependent on using borrowed money to finance too many purchases that you cannot afford based on your current income level. A high debt-to-income ratio also implies that you use up a big portion to repay your loans, hence you have very little savings. Always keep a healthy ratio and don’t push your credit card limits to the maximum or apply for more credit to purchase things that you cannot afford. They all add up and show in your credit rating. |
| Have a loan plan that works with your financial plan
Before committing to any loans, it is wise to draw up a ‘loan plan’ that works with your financial plan and goals, and here are some points to note when putting together your plan.
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