What Is Credit Criteria?
Credit criteria describes the different factors that lenders consider in underwriting, which ultimately results in a determination on 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 an established set of criteria which helps them to judge the risks of lending to different borrowers.
- Five categories of credit criteria with different applicable weights are used to determine a credit score.
- Lending institutions can choose from a variety of credit scoring models based on their specific standards.
- Lenders typically begin the underwriting process with a credit report and credit score but beyond that they can use any legally legitimate criteria they choose in making a credit decision.
Understanding Credit Criteria
Each lending institution has its own set of credit criteria. In general, most institutions develop their basis for credit criteria from a credit scoring model and the criteria that models use. The lending institution and type of credit being offered will be a part of determining the specifics for a lending product’s credit criteria.
There are two main credit scoring systems available for lenders to use in consumer credit underwriting. These two systems are Fair Isaac Corporation (FICO) and VantageScore. FICO and VantageScore both have several iterations or versions of a credit score that lending institutions can use depending on their credit criteria choices.
FICO and VantageScore both bring new scores to market when changes to the methodologies have been made. Some of the most well-known versions include:
- FICO Score 9
- FICO Score 8
- VantageScore 4.0
- VantageScore 3.0
To gain the best understanding of the exact credit criteria a lending institution uses, it is best to find the scoring methodology they use in underwriting. Regardless, all credit scoring methodologies use five basic criteria. The amount of weight placed on each of the criterions can be something that varies with each scoring methodology. In general, the following criteria and weights are typically used in a credit scoring methodology that a lending institution deploys:
Payment history: Payment history is usually the biggest determinant in a credit score with a weight of around 35%. It considers delinquent payments over the past seven years. Longer delinquencies and multiple delinquencies have the greatest impact.
Credit utilization: Credit utilization is the second most important factor with a weight of around 30%. This criterion looks at the percentage of credit being utilized in comparison to a consumer’s available credit.
Age of credit: Age of credit usually accounts for around 15% of a credit score. From this criterion, lenders are interested in the new accounts that have recently been opened as well as the average age of credit accounts. A higher average age of credit leads to a better score and vice versa.
New inquiries: New inquiries account for approximately 10% of a credit score. Inquiries stay on a borrower’s credit score for two years. The more inquiries a borrower has within a short timeframe, the higher of a risk they are to lenders.
Mix of accounts: Mix of accounts is the fifth criterion in credit scoring. It also accounts for around 10%. In this category, lenders are looking for credit account variance rather than a focus on particular credit product like credit cards.
The 5 Cs of Credit
The criteria above form the basis for credit scoring. Most all serious lenders considering a borrower for a credit product will begin with a hard inquiry that results in a single credit score. Some lenders will set a specific credit score level and approve all borrowers based on that. In other cases, lenders may do more due diligence.
Broader due diligence may encompass the involvement of what can be known as the 5 Cs of credit. These “5 Cs” include character, capacity, collateral, capital, and conditions.
- Character is also sometimes referred to as credit history which is usually fully detailed in a borrower’s credit report. This means that lenders look at a borrower’s financial history, usually going as far back as seven years. Credit history on the credit report will include any judgements, liens, bankruptcies, or debts that have gone into collections. Some of these things may or may not be reflected in a credit score. A person’s credit report will contain this information and is usually obtained through the credit bureaus Experian, TransUnion, and Equifax, along with a single credit score summation.
- 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. The same process usually happens with a car loan.
- 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.
Lenders can choose to use any combination of credit criterions in their lending decision. Each lending decision will also vary heavily depending on the credit product in question. In the underwriting process, it is up to the lender to analyze each application and make their own judgement.
Things That May Not Be Used as Credit Criteria
Any single legitimate credit criterion can be used to deny credit to a 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, marital status, age, or enrollment in public assistance programs. This applies to borrowers seeking loans to help pay for education, a house, a home remodeling, the purchase of a car, or the financing of a business. Discrimination based on any of these factors is illegal in the United States and is enforced by the Federal Trade Commission (FTC).