Imagine how things would have been in case lenders would be approving each and every application they receive! I don’t think it would have been possible to sustain businesses.
There is always a probability of borrowers not obeying their obligations. Whenever a loan defaults, lenders incur significant losses.
Even if the loan amount may be recovered with time, the cost involved in the recovery process could quite high. For this reason, lenders subject borrowers to eligibility tests before they approve loans.
It is vital to assess borrowers and their ability not only to repay the loan but also to do that within the required time.
There are so many indicators that might be used in this regard.
One of the most popular approaches is the credit score. This is a three-digit value used to evaluate the creditworthiness of borrowers. Other common tools used include the debt to income ratio, the net asset value, and proof of income.
But what is involved in the assessment process? Well, in this discussion, we are going to examine the concept of credit evaluation and the significance of the three C’s of credit. You will benefit fully by following right to the end.
Credit evaluation refers to the process borrowers are subjected to for them to be eligible for funding, or to pay for products within a specified period.
It as well refers to the step’s lenders undertake while examining the request for credit. Loan approval depends primarily depends on the two parties, the lenders and the borrowers.
For instance, the lender must be willing to offer credit after assessing the capacity of the borrower to obey the obligation fully.
On the other hand, the borrowers must demonstrate the willingness and the ability to repay the principal amount and the interest within the agreed period. In general, small business is required to seek approval in order to qualify for credit.
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When lenders approve a loan application and give funds, they are often convinced and have total confidence in the creditworthiness of the respective borrowers.
We talk of creditworthiness; we refer to the borrowers’ capacity as well as the willingness to repay the borrowed money.
As we mentioned at the outset, there are several tools used in the evaluation of credit.
In case the borrower is the business, the lenders focus more on the statement of financial position and income statements, the rate of stock turnover, the efficiency of the management, debt structure, and the prevailing marketing conditions.
In general, lenders prefer dealing with borrowers with positive cash flows and net earnings that meet any likely debt obligation. Credit evaluation involves the following variables;
This consists of a record of trustworthiness, including borrowers’ moral character, as well as the possibility of consistent performance.
Lenders offer lower rates and better terms to borrowers with excellent credit scores. This is one of the most important eligibility requirements for most lenders.
The debt burden
To be approved for a loan, lenders require your earning power to surpass the payment schedule requirements significantly.
The debt size is primarily restricted by the resources currently available. A secure debt to capital ratio makes it easy for lenders to approve loan applications.
Lenders often prefer jumbo loans for a simple reason – the administrative costs lessen in proportion with loan size. Borrowers as expected to have the potential to ingest a considerable amount of money.
The rate of borrowing
Clients who frequently borrow often establish a good reputation with lenders. This has a bearing on their capacity to obtain credit at better terms.
The period of commitment
Generally, lenders take more risks with the increase in the timeframe. To provide for the additional risks, lenders often increase the interest rate. They usually charge higher rates for loans that take a long time.
These are the basics the borrowers are supposed to keep in mind. These variables play a significant role when it comes to credit evaluation.
But we mentioned about the three C’s of credit at the outset. What are they?
The Three C’s of Credit
A credit score is a three-digit number used to evaluate the creditworthiness of borrowers.
The score ranges from 300 to 850 points. It is such a comprehensive formula that takes into account several factors, including how a borrower dealt with previous credit, the current debt obligation, and the level of income.
The score is dynamic and might change either positively or negatively. The critical factor determining the direction of the movement includes the accrued debt as well as how one manages bills.
The factors that influence an individual’s credit score are referred to as Three Cs of credit score and include the following;
These are the critical areas that lenders pay attention to while deciding whether to lend you. The following is a brief overview of each of these factors.
Lenders often try to determine if you are characterized by the rectitude and trustworthiness to pay back the loan. The following questions may be asked;
- Have you ever utilized credit?
- Are you able to settle your bills right on time?
- Is your credit history good?
- Are you able to offer credit reference?
- For how long have you been working where you are now?
The lenders may want to determine if you have such assets as real estate or automobiles. The following questions might be asked.
- Which property can you use to secure the loan?
- Do you have any investment that can be used as security?
This is the potential of a borrower to pay back the loan. In this regard, the following questions might be asked:
- Is your work steady?
- How many payments are you supposed to make?
- What is your prevailing debt
The Bottom Line
Credit evaluation is very essential. It helps lenders make the right decisions when it comes to extending loans to borrowers, in this blog, we have discussed the concept of loan evaluation as well as the three Cs of credit.