Creditworthiness is how a lender determines that you will default on your debt obligations, or how worthy you are to receive new credit. Some lending institutions also consider available assets and the number of liabilities you have when they determine the probability of default. What are the criteria used to determine your creditworthiness?
According to Investopedia, the following 5 C’s are used to determine Creditworthiness:
Capacity
Lenders must be sure that the borrower has the ability to repay the loan based on the proposed amount and terms. For business-loan applications, the financial institution reviews the company’s past cash flow statements to determine how much income is expected from operations. Individual borrowers provide detailed information about the income they earn as well as the stability of their employment. Capacity is also determined by analyzing the number and amount of debt obligations the borrower currently has outstanding, compared to the amount of income or revenue expected each month.
Most lenders have specific formulas they use to determine whether a borrower’s capacity is acceptable. Mortgage companies, for example, use the debt-to-income ratio, which states a borrower’s monthly debt as a percentage of his monthly income. A high debt to income ratio is perceived by lenders as high risk, and it may lead to a decline or altered terms of repayment that cost more over the duration of the loan or credit line.
Capital
Lenders also analyze a borrower’s capital level when determining creditworthiness. Capital for a business-loan application consists of personal investment into the firm, retained earnings, and other assets controlled by the business owner. For personal-loan applications, capital consists of savings or investment account balances. Lenders view capital as an additional means to repay the debt obligation should income or revenue be interrupted while the loan is still in repayment.
Banks prefer a borrower with a lot of capital because that means the borrower has some skin in the game. If the borrower’s own money is involved, it gives them a sense of ownership and provides an added incentive not to default on the loan. Banks measure capital quantitatively as a percentage of the total investment cost.
Conditions
Conditions refer to the terms of the loan itself, as well as any economic conditions that might affect the borrower. Business lenders review conditions such as the strength or weakness of the overall economy and the purpose of the loan. Financing for working capital, equipment, or expansion are common reasons listed on business loan applications. While this criterion tends to apply more to corporate applicants, individual borrowers are also analyzed for their need for taking on the debt. Common reasons include home renovations, debt consolidation, or financing major purchases.
This factor is the most subjective of the five Cs of credit and is evaluated mostly qualitatively. However, lenders also use certain quantitative measurements such as the loan’s interest rate, principal amount, and repayment length to assess conditions.
Character
Character refers to a borrower’s reputation or record vis-à-vis financial matters. The old adage that past behavior is the best predictor of future behavior is one that lenders devoutly subscribe to. Each has its own formula or approach for determining a borrower’s character, honesty, and reliability, but this assessment typically includes both qualitative and quantitative methods.
The more subjective ones include analyzing the debtor’s educational background and employment history; calling personal or business references; and conducting a personal interview with the borrower. More objective methods include reviewing the applicant’s credit history or score, which credit reporting agencies standardize to a common scale.
Although each of these factors plays a role in determining the borrower’s character, lenders place more weight on the last two. If a borrower has not managed past debt repayment well or has a previous bankruptcy, their character is deemed less acceptable than a borrower with a clean credit history.
Collateral
Personal assets pledged by a borrower as security for a loan are known as collateral. Business borrowers may use equipment or accounts receivable to secure a loan, while individual debtors often pledge savings, a vehicle, or a home as collateral. Applications for a secured loan are looked upon more favorably than those for an unsecured loan because the lender can collect the asset should the borrower stop making loan payments. Banks measure collateral quantitatively by its value and qualitatively by its perceived ease of liquidation.
The capacity and character are generally available on another important “C” and that is your Credit Report! But, are these reports accurate?
According to Credit Secrets[1], these reports are notoriously filled with errors; including accounts being reported incorrectly by date, status, age of the account, and much more. Under the FCRA, tradeline entries on your report must be removed if they fall into either of the following categories:
Inaccurate – an item is not yours, your high balance, account number or monthly payment amount is incorrect, a closed account is listed as open (or vice versa), the date of last activity is incorrect, etc.
Incomplete – a field is blank, a number or word is truncated, a number or letter is missing, false numbers or letters are added, or something is reported in the wrong field
Unverifiable – you may want proof that a debt collector has the right to collect from you, and you come to find out that they don’t have your original hand-signed contract on file anymore – paperwork gets lost. No proof of contract means no authority to report or collect from you. Or how about a late pay – does the creditor have proof in the form of your canceled check?
The credit bureaus are private (non-government) institutions that are the repository for our private information. This information is called a credit file and is populated by furnishers whenever you complete an application for housing, a job, credit cards, an auto loan, mortgage, etc.
When a credit report is requested, the information delivered to the requester looks different depending upon the requestor. An auto finance department, mortgage company, financial institution . Know this, the credit file referenced above is full of information that would likely shock you if you ever saw it all in one place; the reality is you’ve only seen a credit report which is a subset of the entire credit file. The more info in the file the more the CB’s generate by selling that information to other interested parties
The credit bureaus maintain these files because, as many of you may know, information is currency. Some characterize credit bureaus as “data brokers”. Why? Because they sell your information to those seeking to sell you credit, those with whom you have an existing financial relationship and, in some instances, those with whom you used to have a financial relationship. Ironically, the credit bureaus know that your file is full of errors and have invented a diabolical scheme to increase their revenue streams – – selling you identity theft products under the guise of helping you prevent anyone posing as you to gain access to credit. Have you ever applied for credit and was denied because of entries that were not yours on your credit report, or tried to authenticate your own account but due to erroneous information on your report (i.e. have you ever lived at 123 walking bridge lane?) that you were unable to answer correctly? If so, you know all about this process.
But, as we have covered, they monetize information in your credit file; does it really matter to them whether or not the information is accurate? In a word, no.
Who reports information on your credit (and character)?
You will likely be familiar with the “Big 3” Credit reporting agencies (e.g. Experian, Equifax and Transunion), but did you know that there are many more? This results from the definition of bureaus, which includes a sprawling spectrum of products and industries ranging from insurance to retail to energy. The Fair Credit Reporting Act (FCRA) further governs all those involved in the consumer report chain of custody – furnishers, consumer reporting agencies (CRAs), and users of consumer information.
According to the American Bar Association, although its name insinuates a limited scope, the FCRA governs more than just traditional credit reports. Rather, the FCRA focuses on any information that can be broadly defined as a “consumer report.” A “consumer report” means “any written, oral, or other communication of any information by a consumer reporting agency bearing on a consumer’s credit worthiness, credit standing, credit capacity, character, general reputation, personal characteristics, or mode of living which is used or expected to be used or collected in whole or in part for the purpose of serving as a factor in establishing the consumer’s eligibility” for credit, insurance, or employment purposes. A “consumer reporting agency,” in turn, is defined as “any person which, for monetary fees, dues, or on a cooperative nonprofit basis, regularly engages in whole or in part in the practice of assembling or evaluating consumer credit information or other information on consumers for the purpose of furnishing consumer reports to third parties.” Thus, the FCRA clearly reaches beyond the spectrum of credit reporting – it extends to criminal and civil records, civil lawsuits, reference checks, and other information obtained by a CRA.
Below are some common FCRA violations, according to NOLO’s website; the lawyers’ point of view:
Given the definition above, other examples of “CRAs” may include the following:
- Innovis
- Lexis/Nexis
- ChexSystems
- Sterling (employment background screening service)
- CoreLogic Rental Property Solutions (tenant screening)
See 2020 list of Credit Reporting Agencies from the CFPB
https://files.consumerfinance.gov/f/documents/cfpb_consumer-reporting-companies-list.pdf
FICO – A FICO score is a credit score created by the Fair Isaac Corporation (FICO). Lenders use borrowers’ FICO scores along with other details on borrowers’ credit reports to assess credit risk and determine whether to extend credit. Scores can be obtained from CreditKarma, Experian 3 Bureau, and My FICO.
Scores range from 300 to 850. A FICO® Score of 670 or above is considered a good credit score, while a score of 800 or above is considered exceptional.
How is your credit score calculated? FICO Scores are calculated using many different pieces of credit data in your credit report. This data is grouped into five categories: payment history (35%), amounts owed (30%), length of credit history (15%), new credit (10%) and credit mix (10%).
Payment history (35%)
The first thing any lender wants to know is whether you’ve paid past credit accounts on time. This helps a lender figure out the amount of risk it will take on when extending credit. This is the most important factor in a FICO Score.
Be sure to keep your accounts in good standing to build a healthy history.
Amounts owed (30%)
Having credit accounts and owing money on them does not necessarily mean you are a high-risk borrower with a low FICO Score. However, if you are using a lot of your available credit, this may indicate that you are overextended—and banks can interpret this to mean that you are at a higher risk of defaulting.
Length of credit history (15%)
In general, a longer credit history will increase your FICO Scores. However, even people who haven’t been using credit for long may have high FICO Scores, depending on how the rest of their credit report looks.
Your FICO Scores take into account:
- How long your credit accounts have been established, including the age of your oldest account, the age of your newest account and an average age of all your accounts
- How long specific credit accounts have been established
- How long it has been since you used certain accounts
Credit mix (10%)
FICO Scores will consider your mix of credit cards, retail accounts, installment loans, finance company accounts and mortgage loans. Don’t worry, it’s not necessary to have one of each.
New credit (10%)
Research shows that opening several credit accounts in a short amount of time represents a greater risk—especially for people who don’t have a long credit history. If you can avoid it, try not to open too many accounts too rapidly.
Analyzing your credit report
Regardless of how rigged the credit game is, under the current financial structure, we need to know how to play it. So, What factors hurt your credit score most? Public records, derogatory accounts and unsatisfactory accounts, in that order.
Public Records
These have the most damaging impact on a credit report; they include tax liens (not reported since 2017 but may re-appear if ), bankruptcies, judgments and other items of “public record” that can be viewed at one’s local court. These are gathered, generally, by Lexis/Nexis.
Derogatory/Unsatisfactory Accounts
Accounts that are being paid late (i.e. more than 30 days, generally).
When analyzing your report, check for errors in dates accounts were opened/closed, dates payments were made, the amount of those payments, balances owed, the name of the creditor, multiple entries from the same creditor, and more. While a creditor is not obligated to report a tradeline, if they furnish information on your credit report, then it must be accurate.
Tax liens used to appear on your credit reports maintained by the three national credit bureaus (Experian, TransUnion and Equifax). Even if you paid the lien, it stayed on your reports for up to seven years, while unpaid liens remained on your reports for up to 10 years.
In 2017, however, all three credit bureaus implemented changes to eliminate civil judgment records (notes that a consumer owes debt to a court because of a lawsuit result) and half of all tax lien data. By April 2018, all tax liens were removed from credit reports by the bureaus.
The updated rules are the result of a Consumer Financial Protection Bureau study that found issues with reporting such information correctly.
Apparently, a lot of judgments and liens were linked to the wrong people, so someone may share your first and last name, maybe live in a different part of the country, and they might have a lien or judgment that might get linked to your file.
How do I fix bad credit?
Below are some preliminary steps that you must take:
- Remove all old addresses and phone numbers from your credit file to ensure information belonging to others is not associated with you
- Dispute all inaccurate information reflected in the tradelines (entries from your creditors) on your report. Once disputed, the creditor or debt collector must mark the entry as “disputed” on each of your credit reports showing that tradeline. Inaccuracies must be modified for accuracy or removed. If not, the furnisher of that erroneous information runs afoul of the FCRA.
If they fail to do so, that constitutes a violation of the Fair Debt Collection Practices Act. https://consumerfsblog.com/2017/07/5th-cir-holds-debt-collectors-obligation-report-debt-disputed-not-limited-§-1692g/
- Be vigilant: check monthly to see if deleted entries creep back on to your report
- If violators are not willing to make the necessary modifications or remove erroneous entries, as appropriate, then you must take further action. We began sending demand letters to persuade these bad actors to comply with the law. When they continued to fail to do so, we filed lawsuits. Please visit our forum (the Squad) to learn more about what we experienced, the tools we used and the outcomes!
[1] Credit Secrets, How One Couple Beat the Odds and Took Control of Their Credit & Finances…And How You Can Too!, Scott & Alison Hilton, January 2020