October 18, 2014
Lenders want to make sure you have the ability to repay your loans and the willingness to use your resources to do so. Both factors are important to a lender because money you do not pay back results in a loss for them. Large losses cost the lender profits and people who work for the lender their jobs. Even on a smaller scale, every loss to a lender results in higher fees and rates for those borrowers who do pay back their loans. Thus, lenders pay a lot of attention to both your ability and your willingness to pay the loan back.
First, any lender wants to make sure you have the ability to pay back your loan. You may be the most honest person on the planet. You have every intention of repaying your loan. Most important, you can demonstrate your honesty to the lender. However, if you have no income, then no lender will lend you money. Even in cases where you can find lendera to loan you money, they will not lend you as much as you want and they will charge you much more interest on the amounts they do lend you. The bottom line is that lenders make sure you have the ability to pay the loan back before they are willing to lend you their money.
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Likewise, you may make lots of money and definitely have the ability to repay the loan with no problem at all. Now the lender makes sure you are willing to pay back the loan. Not everyone who has money is responsible with it. Again, a lender may decide not to lend to you or to lend to you at a higher interest rate if you have a history of making late payments or missing them altogether. So how do lenders determine if someone is able and willing to pay back a loan? They use the five C’s of credit.
The five C’s of credit are character, capacity, capital, collateral and conditions. Each is intertwined, and lenders use all five to assess if they will lend to you, and if so how much and at what cost. Let’s look at each.
Character is your willingness to pay your bills on time. Your credit history is the key here. Late payments may be an indication that you are not as serious about your financial obligations as you should be. Most creditors won’t report a late payment until it is more than 30 days late. So late payments raise a “red flag” to lenders and hamper your ability to get the loan or at best increase the rate you have to pay.
Capacity is your ability to pay the loan. Do you have the financial resources to pay the loan when it is due? Typically this comes from your income. Do you have enough income after all your other obligations to pay back the loan? Lenders usually do not like to see your debt payments (home, car, credit cards, and other loans) exceed roughly 36 percent of your gross monthly income. Anything more is a sign to a lender that you do not have adequate resources to pay the loan on time.
Capital refers to your assets (the things you own). Here the lender is trying to see if you could sell anything to satisfy the loan in a worst-case scenario. Closely related to this is your net worth. It helps the lender understand if, over time, you are moving in the right financial direction. A negative net worth is not necessarily bad. It depends on the circumstances. A college graduate at age 22 who has a negative net worth of $15,000 from student loans is in much better shape than a 45-year-old with a small positive net worth.
Collateral is a specific asset of some value that you own that is pledged to the lender. It can be taken away by the lender and sold to satisfy the debt if you do not pay the loan. You typically receive better loan terms when you provide collateral like your house or your car for a loan.
Conditions take into account the big picture. What economic conditions, typically beyond your control, could affect your ability to repay the loan? Are you working in an industry that is currently downsizing? How well is the economy in general doing? Did you leave your last job of ten years to go to work for a new company? When the economy is good, credit is readily available and relatively cheap. When the economy is sour credit is more difficult to get and more expensive.
Len Rhodes is director of technology, information and operations in the College of Business at East Carolina University.