When a lending institution (aka a bank, car dealership, mortgage company, or student loan organization) wants to determine if you are credit-worthy, a few factors come into play. Some of their processes are obvious, others aren’t.
In this article, I am going to pull back the curtain by showing you what matters and give a few tips along the way. If it sounds like I’m showing you all of my Financial Coach secrets, I pretty much am. 😉
Understanding Your Credit Risk
Their main goal is to figure out if you’ll actually pay back the money or if you will leave them high and dry. Determining your credit risk is so important that creditors have departments dedicated to making that decision.
The 5 Cs of Credit
C Number One: Character
This is in reference to your credit history. How have you handled debts in the past? The best way for a creditor to get this information is two-fold.
Your Credit Score
One of the most important numbers in your financial arsenal is your credit score. Understanding the makeup of your credit score is a great place to start. But there is more to the story.
Although ranges vary depending on the credit scoring model, here’s the most common breakdown.
According to Equifax, “Lenders generally see those with credit scores 670 and up as acceptable or lower-risk borrowers. Those with credit scores from 580 to 669 are generally seen as “subprime borrowers,” meaning they may find it more difficult to qualify for better loan terms. Those with lower scores – under 580 – generally fall into the “poor” credit range and may have difficulty getting credit...”
A few tips to increase your credit score
Pay your bills on time, every time– even one missed payment may result in a decrease that can feel dramatic.
Keep your credit card balances below 30% of the credit limit– aim for 10% if you want an excellent credit score. For example: If your credit limit is $20,000, keep your balance between $2,000-$6,000.
Apply for credit sparingly– the more a lender pulls your credit, the more dings your credit score endures. There are a few exceptions here, but this is a rule of thumb.
Pro Tip: Finding out your own credit score (not having a lender involved) has zero impact on you.
Your Credit Reports
Checking your credit reports regularly is an underrated financial practice. Per legislation, you can get three free credit reports each year–one from each credit bureau (Experian, Equifax, and TransUnion). You’ll never know if something is amiss unless you look. The safest place to do this is Annual Credit Report.
Did you know: According to the Federal Trade Commission (FTC), one in five people will have a credit error on their credit report.
C Number Two: Capacity
Capacity refers to the ability to repay your loan. They determine capacity by looking at how much debt you have to your name and comparing it to your income. Which leads us to…
Debt-to-Income Ratio
This is also referred to as your DTI. It shows the creditor how much of your income is going toward debt. This number is calculated by adding up all of your debt payments and dividing it by your gross (pre-tax) income. The lower your DTI, the lower your credit risk.
There are two DTI ratios: front-end & back-end.
Front-End DTI
This number only includes your housing expense.
An example:
Your monthly gross income is $10,000.
Debts | Minimum Monthly Payment |
Mortgage Payment* (or Rent) | 2,200 |
Homeowners (or Renter’s Insurance) | 115 |
TOTAL | 2,315 |
*This number should include your principal, interest + taxes
Front-end DTI = Debt Payments / Gross Income
Front-end DTI = 2,315/10,000
Front-end DTI = 23%
A lender is generally looking for a front-end DTI equal to 28% or less.
Back-End DTI
This number includes your housing expense plus all other debts.
An example:
Your monthly gross income is $10,000.
Debts | Minimum Monthly Payment |
Mortgage | 2,200 |
Homeowner’s Insurance | 115 |
Car Loan | 455 |
Credit Card 1 | 110 |
Credit Card 2 | 75 |
TOTAL | 2,955 |
DTI = Debt Payments / Gross Income
DTI = 2,955/10,000
DTI = 30%
A lender is generally looking for a back-end DTI equal to 36% or less.
C Number Three: Capital
Capital is what you have available to put toward the loan, known as your down payment. Capital One says, “Typically, the larger the down payment, the better your interest rate and loan terms. That’s because down payments can show the lender your level of seriousness and ability to pay back the loan.”
C Number Four: Collateral
Collateral is your skin in the game. If you’re looking to get a secured loan or a secured credit card, the creditor wants some level of security. This comes in the form of how much of your own assets you are putting up against the loan. Then, if you can’t make payments, you forfeit that collateral.
Another example of collateral is the vehicle you are purchasing. If you default, they can repossess your car.
C Number Five: Conditions
In short, this is the “other” category.
What you can control:
A creditor may be willing to lend money for a specific purpose, as opposed to a personal loan that can be used for anything.
What you can’t control:
Lenders look at the conditions of their own business and the economy.
Racial Factors
I would be remiss if I didn’t mention that there is a lot of proof that the color of our skin may be a determining factor in whether or not we are approved for a loan.
And I’d like to introduce you to one of my favorite couples in the financial space. I learn a lot from Rich & Regular; they posted about it, too.
The Bottom Line
There’s a lot that goes into determining our credit risk, some within your control and some not. All you can do is review the above and determine which steps will increase your creditworthiness.
Here's to you,
Melissa Mittelstaedt
Money Coach | Accredited Financial Counselor®