Ever since the global financial crisis in 2008, banks and other financial institutions have become more stringent with their lending policies and practices.
They began to reduce their lending as a result of the harsh economic conditions, rising unemployment and a lack of foreign direct investments. These developments forced the financial institutions to revisit their credit risk policies in an effort to safeguard the funds of shareholders, depositors and other stakeholders.
Contrary to popular belief, if a bank declines your request for a loan, it would be incorrect to say that they are not lending you THEIR money. Rather, they are not lending you OUR money.
Many people believe that a good paying job, a steady stream of income and no credit history will automatically qualify them for a loan. However, this is not the case. Many institutions use different instruments to determine whether you fit the criteria for a loan. The most widely used tool is called ‘The Five Cs of Credit.’ These five factors are used to determine the credit worthiness of potential borrowers and the likelihood of them defaulting on their loans. Let us explore those five Cs, namely Character, Capacity, Capital, Collateral and Conditions.
Character
This measure is used to evaluate the borrower’s reputation to try and determine future behavioral patterns, including the individual’s employment history, and their references. It also involves a face- to-face interview to assess the loan applicant’s character (qualitative method). The quantitative methods used include credit ratings or credit checks, which is basically a detailed list of your credit history,consisting of information provided by lenders that have extended credit to you, the types of credit you have received, your payment history, and more.
It is very important for a financial institution to be comfortable with a borrower’s character. A mixture of a good credit history, integrity and honesty will make it easy to qualify for a loan, since these factors show the willingness and capability to repay.
Capital
Capital is the sum of money one pays down towards an investment for which he/she is requesting a loan, for example a down payment on a house or car. Banks love borrowers with a lot of capital as it is an indication of financial strength acquired through accumulated wealth over a period of time. Capital also takes into account a borrower’s overall ability to withstand volatility. It represents savings, investments and other valuable assets that can help with loan payments.
Capacity
One’s capacity to repay a loan is vital to a financial institution in order to determine credit worthiness. Capacity is a measure used to determine a borrower’s ability to generate cash to repay the principal and interest on a loan and thus mitigate the probability of a debt default. Most lending institutions use financial ratios to assess one’s financial capability. In addition, a cash flow statement is requested in order to get a true reflection of the client’s receipt and dissemination of cash. Past income and employment history are also considered in determining your ability to repay a debt.
Collateral
Collateral is an asset that a borrower pledges as a security for a loan. For most car loans, the car itself is the security. For student loans land can be used as collateral. Should one default on a loan, the bank invokes their lien on the property and exercises their right to claim ownership. Loans secured by collateral are considered less risky than those that are not.
Because of the current financial climate, most banks require some form of collateral to qualify for a loan. Collateral is measured by its value and ability to be sold quickly on the market, or to be liquidated. Therefore, before you go to the bank for a loan, which will most likely require collateral, ensure that your proposed asset is valuable enough to be recovered by the bank through a sale should you default on your loan repayments.
Conditions
Conditions refer to the terms of the loan agreement as well as the economic climate that might affect a borrower’s ability to repay a loan. For example, if a hospitality worker applies for a car loan in an economic climate where tourism is dwindling, with no hope of rebounding in the short term, a bank might consider this a reason not to grant the loan. Conditions include interest rates and length of payment. Banks must be able to have a clear picture of the economic climate in which a potential borrower is operating and its likelihood to affect cash flow and the repayment of a loan. Attention to industry trends and economic activity is key for all loans officers and credit analysts.
Now that you know what banks and other financial institutions require in order to grant loans and credit facilities to clients, you can better prepare for your next trip to the bank, ready to answer questions relating to your application. After all, the bank would love to grant you a loan if you qualify, so that it can continue to pay you and other fellow depositors interest on your savings.
