WHAT IS Credit Criteria
Credit criteria describes the different factors that lenders look at when determining whether to lend money to a prospective borrower. Banks and other financial institutions make money by lending and then charging interest on loans. However, if a borrower fails to make payments and defaults on a loan, the bank will suffer a loss of revenue. This is why financial institutions have established a set of criteria to judge whether or not a borrower poses too great of a risk for a loan.
BREAKING DOWN Credit Criteria
Credit criteria can often be stated as including the 5 Cs of Credit. These “5 Cs” include character, capacity, collateral, capital and conditions. While other factors may contribute to how a lender views a potential borrower, these five criteria form the basis of most evaluations of credit-worthiness.
Character is also sometimes referred to as credit history. This means that lenders look at a borrower’s financial history, usually going as far back as seven years. Credit history will include any judgements, liens, bankruptcies or debts that have gone into collections. A person’s credit report will contain this information and can be obtained through the credit bureaus Experian, TransUnion and Equifax.
Capacity describes the borrower’s realistic ability to repay the debt. It examines their current income and compares that to any preexisting debt. The financial institution can then determine whether they believe the borrower has enough disposable income to take on another regular payment.
Collateral describes an asset that can help secure the loan because of its own value. For example, when a person obtains a mortgage to buy a home, the home is the collateral for the mortgage. If the borrower defaults on the loan, the bank takes possession of the property.
Capital describes the amount of money that a borrower already has on hand to pay for the investment. The larger a borrower’s initial down payment, the more credit-worthy they appear, and the less likely they are to default.
Conditions of the loan have more to do with the lender’s judgments about the purpose of the loan and its timing. Lenders may only be willing to offer loans at a specific interest rate, or for a lower principal amount than a borrower has requested.
Things That May Not Be Used as Credit Criteria
Any single legitimate credit criterion can be used to deny credit to the prospective borrower. However, lenders must obey all laws of the credit protection act. The Equal Credit Opportunity Act (ECOA) made it illegal for lenders to reject a credit application based on race, color, religion, national origin, sex or marital status, age or enrollment in public assistance programs. This applies to borrowers seeking loans to help pay for education, a house, remodeling a home, purchasing a car or financing a business. Discrimination based on any of these factors is illegal in the United States and is enforced by the Federal Trade Commission (FTC).