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Your creditworthiness is what creditors consider when determining if they should approve you for a loan or credit card. More specifically, creditworthiness is how lenders determine your risk of defaulting on your loan obligations and if you are worthy of their credit product. Several factors comprise creditworthiness, such as your past repayment history, credit score, assets, and liabilities.
Key Takeaways
- When creditors consider approving you for credit, they look at your creditworthiness as well as your credit score
- Personal loans help you build credit and, when managed properly, look favorably on your creditworthiness
- The five Cs of credit are character, capacity, capital, conditions, and collateral
- Factors such as age, gender, religion, income, etc., do not factor into your creditworthiness
What Factors Determine the Creditworthiness of a Borrower?
While the five Cs of credit were determined around businesses and business lending, those same factors align with creditworthiness for individual borrowers.
- Character - From a lending perspective, creditors want to look at your credit history and establish how often you made on-time payments. Looking at your character helps them establish if you are a worthy credit risk.
- Capacity - While we all think we can take on more credit, the truth is that there is a fine line where the amount we take on makes it more challenging to make those minimum monthly payments. And if we only pay the minimum amount due, our balances can start to rise because we can end up paying more in interest than the principal balance. Lenders want to see a low debt-to-income (DTI) ratio. A general rule of thumb is to keep your overall debt-to-income ratio at or below 43%.
- Capital - This factor applies to sizeable loans such as for a mortgage or a new car. Creditors want to know what investment you will apply to the purchase before the loan begins. The more you apply towards a downpayment, the less risk the creditor takes on.
- Conditions - This is all about your financial and employment stability. In some cases, this also brings in the terms of your loan, such as the interest rate you will pay and your minimum monthly repayment requirement.
- Collateral - For sizeable loans, creditors want to know that you have some assets they can go after if you default on your loan. However, as you build your credit history and maintain a high score, the need for collateral becomes less and less.
- Income - Now that we have the five Cs out of the way, let’s review some other factors that determine your creditworthiness. One of which is income. A higher income generally leads to a better creditworthiness rating, as lenders view individuals with higher incomes as having a greater ability to repay loans. A low income may indicate to lenders that a person is more likely to default on their debts, which can negatively impact their creditworthiness. The debt-to-income ratio, which compares a person's monthly debt payments to their monthly income, is also an important factor in determining creditworthiness
- Credit score - Of course, lenders will look at your credit score when determining your ability to take on more credit. A high credit score generally indicates that you know the importance of making on-time payments and can handle your utilization.
- Derogatory information - Creditors want to see that you have a history of good financial decisions. If they see activities such as collection accounts, repossessions, foreclosures, and bankruptcies, it can raise a red flag and indicate that you are a credit risk.
Which Factors Don’t Determine Creditworthiness?
There are some other factors that do not affect your credit scores or your creditworthiness in the eyes of a lender. And many people think that their income directly impacts their ability to get credit. The truth is that your exact income doesn’t matter; it’s your debt-to-income ratio that does.
Here are some other factors that do not influence your creditworthiness. In fact, according to the Equal Credit Opportunity Act (ECOA), it is often illegal for lenders to consider these factors.
- Bank account balances
- Retirement accounts
- Assets
- Your age
- Religious beliefs
- Race, color, or national origin
- Gender
- Whether you receive public assistance
The Importance of Maintaining Good Creditworthiness
Maintaining your good creditworthiness goes hand in hand with taking steps to maintain or improve your credit score. Conversely, the opposite holds true as well.
- Impacts your ability to borrow - If you have a good credit score and can demonstrate positive traits related to the five Cs, you will have a greater ability to obtain loans and credit cards and the terms and interest rates you will receive.
- Building a good credit history - Paying your bills on time and maintaining a low debt-to-income ratio (under 43%) will help you build a good credit history that will look favorably in the eyes of the lender. And while we indicated that a DTI of 43% or under is critical, some lenders favor a lower DTI of 35% or even 28%.
- Protecting your financial future - Poor credit can have long-term consequences on your ability to obtain loans. For example, personal loans for excellent credit are more likely to have lower interest rates, higher borrowing limits, and more favorable terms than personal loans for people with fair credit.
- Be prepared for a change in your financial situation - Many borrowers make decisions in the present but forget to plan for the future. Now more than ever, consumers need to understand the changing economy and state of employment. To help protect your creditworthiness, consider investing money into a savings account or rainy day fund, just in case.
- Making informed financial decisions - Any time you consider taking on new credit, be mindful. Can you afford the increase to your monthly financial requirements? Will you be able to make your monthly payments on time? Will your next purchase increase your utilization to over 30%? All of these decisions are critical to helping you protect your credit score and your creditworthiness for the future.
For example, if you jump from job to job or have inconsistent employment history (character), it can make it hard for you to keep up with your bills, thus lowering your credit score. And payment history counts for 35% of your credit score, so it's a good idea to stay in check, even if you have just to make the minimum payment.
How to Check Your Creditworthiness
As a borrower, it is important to stay on top of your credit score and credit report. The three prominent credit reporting agencies that measure creditworthiness by generating a credit score on your behalf, are Experian, Equifax, and TransUnion. Lenders and creditors pay these agencies for access to your credit data. As such, knowing your credit score is important.
Many banks and credit card companies offer free access to your credit score each month (and some any time you want). Checking in on your credit score every 30 to 45 days can help let you know where you fall within the FICO score range. And you can see if your score is working its way upward or downward. If you see your score dipping consistently each month, it can be an indicator that something has gone awry. Either you have missed some payments, your utilization is too high, or perhaps there is an error on your credit report.
To that end, just as it is important for you to keep tabs on your credit score, you should check your credit report at least once per year. You can request a free copy of your credit report directly from the credit bureaus or through annualcreditreport.com. If you see an error on your report, file a dispute with the applicable credit bureau (Experian, Equifax, or TransUnion).
The Importance of Checking Your Credit Report Regularly
Regularly checking your credit reports can help you stay aware of what lenders may see:
- Checking your credit report can help you detect any inaccurate or incomplete information
- Checking your credit file regularly can help you spot potential identity theft or fraud early
- Checking your credit report regularly is part of good credit hygiene
How to Improve Your Creditworthiness
To understand how to improve your creditworthiness, you should understand the factors that directly impact your credit score. Those factors and their respective weights are as follows:
- Payment history, 35%
- Amounts owed (utilization), 30%
- Credit history, 15%
- Credit mix, 10%
- New credit, 10%
Paying your bills on time every month is the single most important thing you can do to not only build credit fast but work towards a good credit score of 670 or higher. But, as you can see above, paying your bills on time is not the only thing you need to do. Here is a more comprehensive list.
- Pay your bills on time every month
- Pay down your credit card balances - creditors like to see utilization of no higher than 30%. However, many borrowers set goals to keep their credit card balances at 20% or less of the credit limit. And 10% is ideal as it allows you some wiggle room in the event of a financial emergency.
- Be mindful before applying for new credit. Though you may be a trustworthy borrower with a good credit score (at least 670), lenders are more likely to approve you for more favorable terms, like lower interest rates, if you have a higher credit score and a healthy credit mix.
- Ensure you have a healthy mix of credit. This means you should avoid having too much of any one type of credit. A healthy mix could be a mortgage or rent loan, an auto loan, a student loan, and one or two credit cards.
- Practice good financial behaviors to help you build a good credit history. Building credit from scratch can take about six months, but building good credit so you can apply for a personal loan for good credit can take even longer.
Common Misconceptions About Creditworthiness
Though we defined creditworthiness above, there are often mixed opinions about what it exactly means. But to address that, discussing the misconceptions about creditworthiness is often easier. Perhaps understanding what it is not can help answer the question; what is creditworthiness better than a vague definition?
Myth # 1: Checking your credit score hurts your credit
This is simply false. In fact, you must check your credit score frequently to see if anything appears out of order. If your score has taken a nosedive, there is a good chance that something has been misreported to your credit report. And in this case, you should file a dispute.
Myth # 2: You can’t get a mortgage if you have a limited credit history
The truth is that while it does take a long time to develop a strong credit history, a short history will not prevent you from getting a mortgage. Conversely, suppose you consistently miss payments on your other credit accounts. In that case, your balances on your credit cards are too high or have a history of poor financial decisions, these items can indeed prevent you from taking out a mortgage with a lucrative interest rate.
Myth # 3: Your job and education affect your credit score
While your job and level of education do not directly affect your credit score, creditors like to see that you have held a stable job or have pursued continuing education. These activities are indicators of stability and responsible behavior that creditors want to see.
Myth # 4: Bankruptcy will get you out of debt
While bankruptcy can help you achieve a better financial situation in the long term, it doesn’t get you out of debt entirely. If you file Chapter 7, your assets will be sold so creditors can recoup some of their losses. And if you file Chapter 13, you may be able to keep your assets, but you will be provided with a payment plan to help you pay off your debt. Depending on how much you owe, this payback process can take years.
Myth # 5: Closing a paid-off account will help your credit score
It can be exciting to finally pay off a bill and see the balance at zero. And the natural inclination is to close out the account. While this can be helpful in some situations, the truth is that it is better to keep the credit line open. Open credit lines with no balance help lower your utilization and also signal to creditors that you know how to manage your debt.
Final Word
Your credit score is a good indicator of your creditworthiness, especially the other factors we mentioned earlier in this article. Specific creditworthiness meaning comprises all of those things such as character, capacity, capital, conditions, collateral, income, credit score, derogatory information, etc. By practicing sound financial decisions, staying on top of the data contained in your credit report, and monitoring your credit score regularly, you are more likely to demonstrate creditworthiness to potential lenders and creditors.
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