Question

How do investors determine or evaluate the borrower's risk? Could you explain it combined with concepts or principles we have learned? (Hint: think the opportunity cost of capital.)

Answer 1

What Is Creditworthiness?

Creditworthiness is how a lender determines that you will default on your debt obligations, or how worthy you are to receive new credit. Your creditworthiness is what creditors look at before they approve any new credit to you.

Creditworthiness is determined by several factors including your repayment history and credit score. Some lending institutions also consider available assets and the number of liabilities you have when they determine the probability of default.

Understanding Creditworthiness

Your creditworthiness tells a creditor just how suitable you are for that loan or credit card application you filled out. The decision the company makes is based on how you've dealt with credit in the past. In order to do this, they look at several different factors: your overall credit report, credit score, and payment history.

Your credit report outlines how much debt you carry, the high balances, the credit limits, and the current balance of each account. It will also flag any important information for the potential lender including whether you've had any past due amounts, any defaults, bankruptcies, and collection items.

Your creditworthiness is also measured by your credit score, which measures you on a numerical scale based on your credit report. A high credit score means your creditworthiness is high. Conversely, low creditworthiness stems from a lower credit score.

Payment history also plays a key role in determining your creditworthiness. Lenders don't generally extend credit to someone whose history demonstrates late payments, missed payments, and overall financial irresponsibility. If you've been up-to-date with all your payments, the payment history on your credit report should reflect that and you should have nothing to worry about. Payment history counts for 35% of your credit score, so it's a good idea to stay in check, even if you have to just make the minimum payment.

Your creditworthiness is important because it will determine whether you get that car loan or that new credit card. But that's not all. The more creditworthy you are, the better it is for you in the long run because it normally means better interest rates, fewer fees, and better terms and conditions on a credit card or loan, which means more money in your pocket. It also affects employment eligibility, insurance premiums, business funding, and professional certifications or licenses.

Checking Your Creditworthiness

The three prominent credit reporting agencies that measure creditworthiness are Experian, TransUnion, and Equifax. Lenders pay the credit reporting agencies to access credit data on potential or existing customers in addition to using their own credit scoring systems to grant approval for credit.

For example, Mary has a 700 credit score and has high creditworthiness. Mary gets approval for a credit card with an 11% interest rate and a $5,000 credit limit. Doug has a 600 credit score and has low creditworthiness. Doug gets approval for a credit card with a 23.9% interest rate and a $1,000 credit limit. Doug pays more in interest over time than Mary.

Every consumer should keep track of their credit score because it is the factor financial institutions use to decide if an applicant is eligible for credit, preferred interest rates, and specific credit limits. You can request a free copy of your credit report once each year, or you can join a free credit monitoring site like Credit Karma or Credit Sesame, which allows you to keep on track of your credit history.