Top 5 Factors Influencing Credit Risk When Getting Personal Loan – Forbes Advisor INDIA
You can never tell when life will throw you a curveball. There may be instances when you need emergency funds – when you don’t have enough cash on hand to meet the needs at hand.
This could include the money needed to pay for marriage or medical expenses, a large purchase, consolidating an ongoing debt, or paying off other expenses that you lack the necessary funds for. In times like these, it makes sense to borrow money.
While there are a plethora of loan options to choose from, let’s find out why a personal loan would be ideal.
Personal loans: what you need to know
When quick money is needed, a personal loan is the best choice considering that this option offers the fastest payout compared to other loans on the market. Given how easy it is to secure a personal loan, an update from the RBI in March 2021 indicated that personal loans had grown by 13.5% (YoY). This just goes to show that more and more people are turning to personal loans to help them meet unplanned expenses and, in some cases, even make ends meet.
Remember, before the lender sanctions a loan, credit risk assessments come into play. Let’s learn more about credit risk assessment and the main factors that influence credit risk in personal lending.
Credit risk: what is it?
In very simple terms, credit risk refers to the risk of loss that a lender faces if a borrower fails to repay a loan or debt. In the personal lending arena, the practice of credit risk assessment is concerned with determining whether or not an individual should be granted a certain amount of credit.
This process takes into account the risk that the lending party must bear in cases where the principal and interest of the loan amount are not received.
With the onset of the pandemic and the ensuing credit crunch, credit risk assessment has come into focus for financial institutions. Credit risk assessment, a process that most financial institutions find difficult, involves analyzing the bank’s capital and credit reserves simultaneously to mitigate the losses incurred by non-performing loans.
As regulators demand more transparency, banks have a responsibility to conduct thorough background checks on their customers and correctly assess the associated credit risk.
When granting personal loans, the challenge lies in correctly assessing whether a private individual can meet the agreed repayment of the borrowed amount or not. The factors that are taken into account are — the loan amount, the payment schedule, and the term of the loan.
Although better access to credit can prove beneficial for the economy as a whole, it is important to assess the credit risk involved. When financial institutions fail to do their due diligence and originate loans without proper credit checks, loan assets become non-performing assets (NPAs), resulting in large losses for the financial institutions and eventually the wider economy.
Key factors affecting credit risk in personal loans
It is important to understand what factors are considered by the lender when evaluating personal loan applications.
Credit risk assessment has a significant impact on interest rates. In cases where a borrower is associated with high credit risk, the lender charges higher interest rates for the capital provided. If the assessed risks are too high, banks and credit institutions can also reject the loan application.
There are five top factors or better known as the “5 cs‘ The credit risk that are measured. When banks, NBFCs and other financial institutions review loan applications, they consider these 5 Cs when assessing the borrower’s creditworthiness and the risks associated with lending. These five factors help lenders not only quantify and decide on the eligibility of a loan applicant, but also help determine interest rates and credit limits for borrowers.
The 5 C’s used to determine a borrower’s creditworthiness are:
The borrower’s ability to repay is the most important of the 5 factors. In personal lending, the customer’s employment history, current job stability, and income level are key indicators of the borrower’s ability to repay the outstanding debt. A balance of income and expenses reflects not only the borrower’s financial standing, but also his ability and prudence in managing the business.
For example, borrowers with school-age children or small business entrepreneurs with volatile cash flows are considered “low capacity” borrowers.
To determine whether the borrower will be able to raise the money required to repay the loan, the debt to equity ratio comes into play. The borrower’s ability to pay is estimated by comparing current income (before taxes) to recurring debt.
This factor is about assessing the net worth of the person applying for a loan. It represents the number of assets owned by the borrower and can range from savings and investments to assets like jewelry.
A good capital rating would indicate that the borrower is sufficiently capitalized to absorb unexpected losses.
While a personal loan uses the current amount of income to repay, the borrower’s capital is considered an additional reserve to meet needs should unforeseen circumstances arise.
External factors such as economic, market and industry conditions are also important in determining the risk that the lender must bear, as they indirectly affect the borrower’s ability to repay.
The goal here is to determine whether the borrower will be able to adjust to changing conditions and be flexible enough to repay the loan throughout its life.
Collateral refers to the borrower’s assets that can be pledged in his name as security for the loan extended. This can include fixed assets like the borrower’s title deeds and even financial assets like bonds.
Collateral is only pledged for secured loans and not for unsecured loans such as credit cards.
What we need to understand here is that collateral is not used to determine a borrower’s capacity. Because collateral is only used in the worst case, if the borrower does not repay the loan.
Character is all about the moral integrity of the borrower – it all comes down to the borrower’s willingness to repay the loan. It judges whether the borrower will meet the loan obligation or not.
Character is by far the most comprehensive aspect of assessing a borrower’s creditworthiness. The borrower’s repayment and loan servicing history is analyzed to determine the borrower’s propensity to repay the loan. If there are indications of payment defaults, this only shows that the borrower has acted negligently or irresponsibly in the past. This could imply a negative character trait, which then leads to lower ratings.
Why are the 5 C’s important?
The 5 Cs provide a basic structure for credit risk assessment. Not only are they vital in setting a framework, but they also help set targets, which in turn allow lending institutions to determine the borrower’s eligibility for a loan.
The credit risk departments of all lenders depend on making data-driven decisions – and the 5Cs of credit risk help them make accurate estimates of a borrower’s creditworthiness.
There are no strict rules by which lenders weight these attributes – different lenders may prioritize one attribute over another. Online lending portals can weigh character and capacity, while banks consider collateral to be the most important.
In addition to these 5 factors of credit risk assessment, credit scores are also taken into account in some cases to check loan applications. However, it can be confusing as to what credit risk and credit score mean and how they can affect the lending process.
Credit Risk Rating vs. Creditworthiness
Both credit risk and credit score are similar in many ways as they are both used to measure borrower credibility. This explains why they end up being used interchangeably!
Let’s clear up all the confusion by first understanding what credit worthiness is and then moving on to the differences between these two concepts.
What is a credit score?
A credit score is an indicator of the customer’s creditworthiness. This numerical score plays a crucial role in the lender’s decision to offer the loan amount. What you need to understand here is that with a personal loan, creditworthiness affects not only loan approval but also interest rates.
It is a number that lenders arrive at by analyzing the customer’s repayment history and other loan details such as loan drawdowns and the tenor of previous debts on different types of loans and lending institutions.
This numeric score helps lenders estimate the likelihood of a customer repaying their debt. A credit score is a three-digit number between 300 and 900. Typically, the higher the credit score, the higher the financial credibility of that customer. Ensuring you make timely repayments on your loan will increase your score, while defaults and delays would negatively impact your score.
Any score above 750 is considered good credit and will allow you to secure credit at lower interest rates. Factors such as credit history, credit utilization and duration, and various factors such as the number of credit applications made in the past may affect your credit score.
Difference between credit risk and creditworthiness
While both credit risk and credit score are influenced by past credit history, the main difference is that credit risk provides a much broader framework for assessing a customer’s trustworthiness. The credit risk assessment takes many more factors into account than we have seen before and is therefore considered more comprehensive and provides a better understanding of the borrower’s creditworthiness.
Because of this, financial institutions are now beginning to prioritize credit risk assessment when considering loan applications. Credit risk assessment has also become an important decision factor for large loans such as mortgages.
While creditworthiness is still used as a crucial factor in evaluating loan applications, many of the new-age FinTechs and lending portals prefer not to rely solely on creditworthiness, instead seeking a broader approach.
In many ways, it’s safe to say that credit risk ratings are now replacing credit scores when assessing a customer’s ability to borrow and repay.