Credit Worthiness: What is its role in credit score and personal loan applications? Find out | Mint

Whenever an individual applies for a credit product like a loan or a credit card, the bank evaluates whether they can approve or reject the application. Among the various eligibility criteria, an important one is to assess whether the individual will repay the credit extended. It is done by evaluating the individual’s credit worthiness. In this article, we will understand what credit worthiness is, how banks evaluate it, and its role in an individual’s credit score and personal loan applications.

What is credit worthiness?

When an individual applies for a loan like a personal loan, the bank needs to do a financial feasibility. The bank needs to assess whether it should approve the loan application, what the loan amount is, whether the borrower will be able to repay all the EMIs on time, etc.

Similarly, when an individual applies for a credit card, the bank needs to do a financial feasibility. The bank needs to assess whether it should approve the credit card application, what the credit limit is, whether the borrower can pay the credit card monthly bill on time, etc.

In both the above situations, whether loan or credit card applications, the bank does the financial feasibility by evaluating the borrower’s credit worthiness. Credit worthiness refers to the borrower’s ability to repay loan EMIs or credit card outstanding on time. It reveals whether an individual is worthy of credit. If yes, how much credit can be extended to the borrower?

The higher the individual’s credit worthiness, the higher the chances of a loan/credit card application getting approved. Similarly, if an individual’s credit worthiness is low, the probability of a loan/credit card application getting rejected increases. In the case of individuals with low credit worthiness, if the bank decides to approve the loan application, it may come with conditions. Some of these conditions can include a higher interest rate, requirement of collateral or guarantor, a lower loan amount, etc.

How do banks evaluate a borrower’s credit worthiness?

The banks evaluated a borrower’s credit worthiness based on certain factors. Some of these factors include the 4Cs as follows.

Character

The borrower’s character can be assessed through their credit score and credit report. The credit score is arrived at after considering the individual’s debt repayment track record, credit utilisation ratio, mix of secured and unsecured credit instruments, ageing of credit instruments, number of credit applications and their frequency, etc.

The details of the debt repayment track record are reflected in the credit report. The report shows the details of all the loans/credit cards that are open and closed. Below every credit instrument, the monthly repayment record is mentioned.

If an individual’s credit score is 750 or above, it is a reflection of their good credit behaviour. The higher the credit score, the better and vice versa. Banks consider a credit score of 750 or above as good for approving credit applications, provided the other eligibility criteria are fulfilled. A good credit score contributes towards increasing the borrower’s credit worthiness.

Capacity

The borrower’s capacity reflects the ability to repay the current loan on time. Banks can assess the borrower’s repayment capacity by calculating the debt-to-income (DTI) ratio. The DTI ratio reflects the percentage of monthly income being used to pay debts (loan EMIs and credit card outstanding). The lower the DTI ratio, the better.

Banks consider a DTI ratio of up to 35% good for approving credit applications. Some banks may consider a DTI ratio between 36% to 50% for approving credit applications on a case-to-case basis. If the DTI ratio exceeds 50%, the chances of credit application approval reduce sharply.

The lower the DTI ratio, the more it contributes towards increasing the borrower’s credit worthiness. On the flip side, a higher DTI ratio erodes the borrower’s credit worthiness. The higher the DTI ratio beyond 35%, the lower the credit worthiness.

Capital

In the case of certain loans, banks ask the borrower to make a down payment. For example, in a home loan, banks usually ask the borrower to make a down payment of around 20%, and the remaining purchase amount is financed through a loan. Similarly, for vehicle loans, banks ask the borrower to make a down payment of a specified percentage.

The down payment is the borrower’s contribution to the asset (house, vehicle, etc.) being purchased. The higher the percentage of the down payment, the lower the probability of the bank suffering a loss in the event of a default. The borrower can increase their credit worthiness by making a larger down payment. The down payment acts as a margin of safety for the bank.

Collateral

If the borrower’s credit score is lower than required and/or if the DTI ratio is higher than required, the bank may ask the borrower to get collateral. In the event of default, the bank can sell the collateral and recover the outstanding loan amount. In the case of some loans, like personal loans, the bank can ask the borrower to get a guarantor. A guarantor or collateral increases the borrower’s credit worthiness.

How to increase your credit worthiness?

We have discussed what credit worthiness is and how banks evaluate a borrower’s credit worthiness. As credit worthiness directly impacts your chances of getting a personal loan, let us discuss some ways to improve it.

Work towards improving your credit score

You can do that by making timely payment of existing loan EMIs and credit card monthly bills. Bring your credit utilisation ratio below 30%. Apply for one credit instrument at a time, and wait for the bank’s final decision before making the next application. Don’t make too many credit applications simultaneously or within a short time span. Have a healthy mix of secured and unsecured loans. Consider retaining your old lifetime-free credit cards even if you don’t use them. All these measures will contribute towards improving your credit score.

Improve your repayment capacity

To improve your repayment capacity for a new loan, you must work on bringing down your debt-to-income (DTI) ratio to 35% or below. You can do that by pre-paying some of your loans either partially or fully. If you have credit card outstanding that you are carrying forward, consider converting that into easy EMIs or a personal loan for ease of repayment.

Make a higher down payment

If a down payment is required, consider making a higher down payment. A higher down payment will give confidence to the bank and increase your credit worthiness.

We have discussed how an individual can improve their credit worthiness. So, the next time you want to apply for a personal loan or any other loan, work on improving your credit worthiness before making the loan application. Improving your credit score is a part of improving your credit worthiness. Beyond improving your credit score, you must reduce your DTI ratio to 35% or below. If the loan requires a down payment, be ready with the required amount. 

Finally, if a guarantor is required, be ready with one. Your credit worthiness is your gateway to getting the required loans that can help you achieve your important financial goals.

Gopal Gidwani is a freelance personal finance content writer with 15+ years of experience. He can be reached at LinkedIn.