Question

Why is it critical to understand the basic concepts of credit?? (answer in 5-6 sentences)

Answer 1

Credit is important part of financing. It i importatnt to understand the basic concepts of credit in order to maintain a good credit rating and hence keep the possibility of availing loans in times of need from the bank.The important concepts and its link to an applicant is as follows (also known as the five Cs):

1, Character: It defines the applicant's credit history. This is used to understand past reputation of applicant for timely repayment of debt.Example is FICO score which ranges from 300-850 which help leners to understand the likelihood that the applicant ill replay loan on time.

2. Capacity: It is also known as Debt to Income ratio (DTI), The DTI is calculated by using the recurring monthly payment divided by the monthly income of the applicant. usually a DTI ratio of 35% or less is preferred by the lenders before approving the loans.

3. Capital:The amount invested by the borrower towards any investment is taken into account while deciding on the rates and terms of the credit. E.g. Loans guaranteed by the Federal Housing Administration (FHA) and the U.S. Department of Veterans Affairs (VA), require borrowers to put down between 2% and 3.5% on their homes.

4. Collateral: Loans backed by collateral are secured as the lender can claim the market value of collateral and recover amount of the applicant defaults on the loan in future.

5.Conditions: The conditional use of the credit like for housing or car increases the likelihood of lender approving the loan when compared to signature loan that can be used for any purpose. Also, conditions refer to the interest rate and principal amount based on country's macroeconomic conditions.

In order to obtain credit at lower cost it is essential to use the above concepts and maintain a good outlook for each of above 5 points.