Looking for a succinct way to understand how banks determine your creditworthiness? Think of the letter C. For years banks have determined a loan applicant’s worthiness by reviewing their capacity, capital, character, collateral and conditions.
* Capacity reflects a person’s ability to repay the loan they are applying for. During the underwriting process, banks will review your ability to create cash flow, which you will need to pay the loan’s accompanying interest. Those who demonstrate a strong cash flow capacity are more appealing because they are more apt to handle the interest requirements that accompany a loan.
* Capital can represent the strength of your personal wealth or the vitality of your business. The greater your capital, the easier you can navigate life events or volatility, making you a more attractive target for lenders.
* Character is perhaps the most important of the five C’s for lenders. Banks want to learn more about what type of person you are, and they will use things like your credit report and credit history to determine if you are a safe subject for a loan.
* Collateral may be offered up to secure a loan from a lender. If you are unable to repay the loan in the future, the lender may then choose to collect through the sale of the collateral provided.
* Conditions is a general term that can apply to any number of final qualifications accompanying a loan. Conditions may also apply to any research the bank is doing regarding your loan. For example, if the loan is for your business, the bank may do some further investigation to understand the conditions that exist in this industry to determine if you are an ideal candidate for the loan.
Cell phones: The sixth C
While banks across the country have set loan rejections and approvals based on the five C's for years, a sixth C is starting to gain notoriety.
The practice started overseas, where millions of people lack proper financial records but possess cell phone records. Lenders abroad and in the United States are now finding these records can be used as a viable factor to determine a person’s creditworthiness. For example, does the applicant pay their cell phone bill on time? Do they manage their balance effectively? How large is a person’s social network?
The considerations here may seem anecdotal, but research finds resounding similarities between the size of a person’s social network and their ability to repay a loan. In many cases, the larger the social network, the less chance of a loan default.
So what does this mean for you? Like your credit card and credit history, your cell phone bill is now something else it pays to watch closely. Pay your bills on time, because when it comes time to apply for a loan, that sixth C may be the most important of all.