The credit system is a funny business. It is a system based on a trust that lenders will lend and borrowers will repay. Lenders get to make a profit from giving out loans and credit, and borrowers get access to funds for emergencies or other investments. Given that banks can borrow low cost money anytime from each other and arbitrage it to the consumer at 10 times the costs, no wonder everyone feels that running a bank is the best business to be in. Usually the bulk of funds come in the form of public deposits at minute interest that hardly matches up to inflation.
And the trust does not go both ways, mind you. Because borrowers are fully expected to return the money that is owed. But lenders are not fully expected to lend the money that is needed by someone. If individuals can be penalized for bad credit, a bad lender system run by consumers should also be imposed on banks where those with poor records will not be able to issue any loans for a period of time until their grading improves. Sure that might put an organization out of business. But who is sparing a thought for the people who are put out of business being unable to get a loan? Double standards? That is a topic for another day.
Banks however, play an important role in the economy. And if the formula that is working have brought us prosperity, who are we to question what should or should not be done.
Over decades and centuries, financial institutions with the help of very intelligent people, have developed complex sophisticated mathematical equations to judge the credit-worthiness of a would-be borrower. The objectives of these researches always concern the balancing act of risks and returns.
Risks
Unless a lender is running other businesses unrelated to finance, their main returns come down to interest rates. So in exchange for access to funds or credit, a borrower will have to compensate the lender in the form of interest rates. This interest is supposedly determined by the market forces of demand and supply. Which is an irony as we can see credit cards charging different rates when they are exactly the same thing. I guess the concept of added-value comes into the picture as well.
When we factor in the risk and return balance, secured facilities tend to have a lower interest rate compared to those that are unsecured. The simple reason being that collateral eliminates considerable risks. A collateral or security is basically an asset that the lender legally repossess should the borrower is found to be in breach of terms and conditions. There are many reasons why collateral can be requested. But they all come down to making the lender feel more comfortable of the risks involved in the deal.
Application
There are basically 5 areas of concern when assessment is made to your loan applications. If you can understand them and why they are of particular concern, you will be able to craft future applications in a manner that puts you in the best light possible.
1) Reason for debt. Depending on the type of loan or facility you are trying to obtain, there might be restrictions on how the funds are to be used. For example, many banks loathe the thought of using home equity loans to buy up more real estate. To them, it is a highly leveraged risky venture. Another example is renovation loans that can only be used to pay off contractors with valid contracts. The underlying theme is low risk. Businesses needing funds for expansion or working capital are legitimate uses of cash that nobody would disapprove. But if you are taking a personal loan for speculating in the futures market, you could have a hard time convincing an approver to grant you what you want.
2) Amount of debt. Although lenders would profit from as high a loan as possible, they seldom allow themselves to succumb to temptation. They are very mindful to gearing up a borrower too much. On the other hand, they have to grant a facility that is sufficient for the borrower to use for the intended purpose. Often times, a loan-to-value (LTV) ratio is used. For example, the purchase of equipment might get 90% LTV or a mortgage might qualify for 80% LTV. Saying that, it is not uncommon for lenders to go for the kill at 100% LTV. But for such a gracious offer, the borrower can expect to pay a high price.
3) Borrowing capacity. This is when credit checks and assessments are conducted. The intention is to assess whether a borrower has the capacity to service the loan. And also to judge whether they are dealing with a good or bad paymaster. To avoid over-leveraging someone with a debt that cannot afford to repay, debt servicing ratios (DSR) are often used. This is basically a ratio that puts the repayment commitment side by side with income. So is there is a monthly debt obligation of $1,000 while income is $4,000, the DSR will be at 25%. Other financial liabilities like auto loans or cash advances might also be factored in for DSR calculation. You can expect this phase to be biased. Meaning any claim of your income must be verified by valid documentation, while any sign of financial liability will be taken into account until you can prove otherwise with valid documents.
4) Term. In many parts of the world the term is also referred to as the tenor. This is something that different departments in financial institutions can fight over. Because while the risks management department will want as short a term as possible to avoid risk, the sales department will want as long a term as possible so that revenue is maximized. It is a balancing act that can make or break an institution. But given the risk-adverse nature of financial institutions, the risks managers usually win.
5) Security. Although secured loans give a lender a smaller profit margin, they make up for it with volume. Secured loans tend to be much bigger in size. The simple reason being that borrowers would want a fair deal when they are pledging highly valuable assets as collateral. How would you feel if you had to pledge your $500,000 house for a measly loan of $1,000? Common sense will say that you would at least ask for half of that or use a less valuable asset in it’s place.
One final item to take note is to read the terms and conditions of facility letters carefully. Look for the fine prints especially those on administrative charges and penalty fees. Running into these costs are just unnecessary.