Concept 48: Credit Worthiness
In Concept 47: Uses of Credit we discussed the advantages and disadvantages of using credit. In order to use credit, however, a borrower must first convince a lender they are credit worthy, or likely to repay their debt. The amount of credit and the interest rate a borrower can get are both related to their creditworthiness. Essentially, the borrower needs to prove that they meet three general requirements, sometimes referred to as the Three Cs of creditworthiness:
- Capacity – the ability to repay, meaning the borrower has a steady source of income
- Character – the borrower has been reliable in the past and based on that, seems likely to repay
- Collateral – the borrower possesses something of value that can be collected if they fail to repay
Determining whether a borrower meets these requirements is typically accomplished through two means – a credit application and review of a credit report. These are described in detail in the next section.
Determining a person’s creditworthiness basically comes down to getting as much information about that person in advance as possible. A credit application is a series of questions used to help determine baseline information about a person’s ability to pay. Credit applications typically ask for basic ID and contact info, current employment, income, monetary obligations (like other loans or child support), how long someone has lived in their current residence, banking information and, occasionally, references. For larger loans some of this information must be verified by submitting pay stubs, tax returns, bank statements or other documentation. This process is good for determining capacity and collateral. Importantly, lenders are not allowed to make credit decisions based on race, gender, marital status or religious affiliation.
Determining a person’s financial character is a bit trickier. To determine how a person has handled past credit, borrowers use credit reports and credit scores. A credit report includes information about existing loans, payment history and how frequently a person seeks credit. This information is provided by one of three companies that specialize in compiling this information. A credit score is a single number derived from a complex formula that is designed to provide an immediate signal to a lender about a borrower’s credit history. The most important factors that go into a person’s credit score are:
- On-time payments
- Percentage of available credit used (not maxing out cards)
- Length of time they have had credit (longer is better)
- The type of credit they carry (variety is better)
- Frequency of asking for new credit (less often is better)
Everyone is entitled to free access to their credit reports each year and should always check them for accuracy. Annualcreditreport.com is the government-endorsed clearinghouse for these, but they are available from each agency as well.
It is tough to overstate the importance of having good credit, especially as you get into stages in life where you want to buy cars, houses, start businesses, etc. Assume three people with equal financial assets currently apply for a $250,000 loan for a house. One has a credit score of 840 (near perfect), one has a 620 (pretty good), and one has a 465 (poor).
The person with an 840 is going to be able to get a loan from almost any lender and will be able to compete for lower interest rates. This matters because the difference between getting a 4.5% interest rate and a 3.75% interest rate on a large loan can mean a lower monthly payment of hundreds of dollars, as well as thousands of dollars saved in interest over the life of the loan.
The person with the 620 score will likely not be able to get that 3.75% interest rate and have to accept something higher than 4.5%.
The person with a 465 may not be able to get a loan at all – which then has a domino effect on their ability to acquire assets.
The good news is you are largely in control of your own creditworthiness through the decisions you make about how to use credit.
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Below are five questions about this concept. Choose the one best answer for each question and be sure to read the feedback given. Click “next question” to move on when ready.
Describe factors that affect credit worthiness and the ability to receive favorable interest rates including character (credit score), collateral, and capacity to pay.
Describe the importance of credit and having a favorable credit score.