In the world of credit, lenders are always concerned about the creditworthiness of their customers and potential customers. But what does that mean exactly? Let’s take a closer look this week.
What does creditworthiness mean?
In a nutshell, creditworthiness means the ability of a customer to repay their debt to a lender and not default. Today, few borrowers have personal relationships with their lenders. Even if they do, most loans end up going before a committee that requires more than a personal relationship to approve a loan. To help determine your ability and willingness to repay a loan, lenders look at past performance to help determine future outcomes.
In other words, all that information on your credit report is used by a group of strangers (lenders) to objectively figure out if they can trust you to pay your bills. Make no mistake—it is up to you and your actions to prove that to the lender. If you cannot, you are likely to be passed over. It’s as simple as that.
Lenders like to see evidence of character, capacity and collateral, known as the three C’s of lending. Your credit reports show your character (do you keep your promises?) and help measure your capacity (how much credit you have successfully handled, or not, before). These two factors can impact the amount of collateral you need to secure a loan at a given rate.
How do credit card issuers determine creditworthiness?
This factor will come into play anytime you apply for credit of any kind. This means mortgage companies, auto lenders and, yes, credit card issuers. Each entity may weigh certain factors differently, but most lenders give extra weight to how you’ve handled similar types of credit before.
For example, car lenders like to see on-time car payments. So while missing a credit card payment is not a good thing, it’s worse from their point of view if you’ve blown off a car payment or two. Being on time with your car note not only shows you pay your bills, but it shows you treat your car loan with serious respect. And who doesn’t appreciate a little respect!
In the case of credit card issuers, they will be most concerned with how you have handled any past revolving debt. Did you pay on time? Did you pay as agreed? If so, chances are you will be seriously considered. But if you have a history of late or missed payments, your chances will go down.
If you have never had any revolving credit (for instance, this is your first credit card), determining your creditworthiness (remember character and capacity) becomes more difficult. While you may still qualify, you may find your rate is higher than you hoped for and your credit limit may also be less than you wanted.
By the same token, mortgage lenders are going to want to know how you have handled your fixed payments in the past and may give more weight to that area. But don’t be fooled into thinking that the other factors are not important for any lender. Credit scoring involves many complex algorithms for all kinds of credit. Who is pulling your credit may be just as important as what is on your credit report. That is why keeping your credit as clean as possible in all areas is always going to be in your best interest.
Why is creditworthiness important?
Creditworthiness is a measure of how trustworthy you are and how much credit you can handle. If you are trustworthy, you keep your promises. So these two measures of your creditworthiness are going to be two of the most important factors in any lending decision. Will you qualify for the mortgage? Can you buy a new car? And what are your chances of getting the best credit cards?
Your credit score displays your creditworthiness as a numeric factor, which makes it easier for lenders to make their decisions. If you want the best credit cards, for instance, you are going to need an excellent credit score. How do you get an excellent credit score? By keeping your promises and also by being careful with when and how much you access the credit you do have.
Remember that while payment history is the No. 1 factor in your FICO score at 35 percent, credit utilization is not far behind at 30 percent. Making all of your payments on time while carrying large balances on your credit cards will mean your score is going to be lower, even though you are keeping your promise to pay on time as agreed.
How can you become more creditworthy?
By doing the things that will improve your credit reports and thus your score. As mentioned, make sure that your bills are all paid on time and as agreed. Keep the balances on your credit cards at 25 percent or lower and remember that those with the best scores have utilization factors in the single digits.
Review your credit mix and determine if you need to add something to give your score a lift. But be cautious here, because new credit will likely ding your score a bit in the beginning. This is why you should only apply for credit when you need to, not just because you want to. Don’t close old accounts unless you have a really good reason for doing so.
Understanding what creditworthiness is will make it easier for you to achieve it. That is always worth striving for. Good luck!
Have a credit score question for Steve? Drop him a line at the Ask Bankrate Experts page.