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Creditworthiness is a term that’s thrown around a lot in the financial world, and you should understand what it means because it plays a key role in many financial decisions.
Lenders evaluate your creditworthiness—or how worthy you are to receive new credit—when you apply for a debt obligation, such as a personal loan, credit card or line of credit. Typically, lenders only extend credit to those they deem as creditworthy borrowers. A creditworthy borrower is one who is able and responsible enough to repay their debts in a timely manner. If a lender believes you are a risky borrower, it’s unlikely that you will qualify for new credit.
To help you understand creditworthiness and what you can do to boost it, we’ll review its importance and the factors that determine it.
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Why Your Creditworthiness Is Important
Your creditworthiness helps lenders determine whether or not to extend new credit to you—it’s a measure of how likely you’ll repay your debt obligations. If you are a trustworthy borrower with a good credit score (at least 670), lenders are more likely to approve you for more favorable terms, like lower interest rates. However, if lenders believe you pose a risk, they may charge you higher fees and offer your smaller loan limits, or deny your application.
6 Factors That Determine Creditworthiness
Lenders look at a lot of factors to piece together your creditworthiness. Each lender also has its own requirements for what they view as creditworthy, so it’s crucial to shop around and compare lenders. However, lenders typically evaluate these six factors when determining your creditworthiness.
1. Income and Debt
In order to repay your debt, you’ll need enough money to make your monthly payments on top of your living expenses. That’s why lenders want to verify your income and understand your overall debt payments, including other loans, credit cards and even rent or child support.
Lenders use your income and debt to calculate your debt-to-income (DTI) ratio. Your DTI measures the percentage of your monthly income that’s claimed by your debt obligations; the lower your DTI, the more creditworthy you appear. Lenders typically like to see a maximum DTI of 36%; however, it’s possible that some lenders will accept a DTI up to 50%.
For example, let’s say you earn $2,000 per month and have $500 worth of loan payments. Your DTI would be 25% ($500/$2,000).
How to Increase Your Income and Lower Your Debt
Increasing your income is tricky. If you could just push a button and do it, we’d all be earning more. You can do things like work side hustles, ask for a raise at your work, switch employers or even switch careers. Increasing your income can have wide-ranging benefits in your life too, such as being able to save more.
Paying down your debt is another excellent way to improve your creditworthiness. It’s best to start with past-due debts. After that, paying down your credit card debt can go a long way. Finally, other types of debt such as student loans or mortgages are also good to pay down.
2. Credit Scores
Your credit score is one of the most important factors lenders use to determine your creditworthiness. FICO credit scores, the most common scoring model, range from 300 to 850.
A higher your credit score represents responsible debt management skills and the likeliness to meet your payment obligations; lower scores pose a risk to lenders.
| Rating | Credit Score Ranges |
|---|---|
Exceptional | 800 - 850 |
Very Good | 740 - 799 |
Good | 670 - 739 |
Fair | 580 - 669 |
Poor | 300 - 579 |
How to Increase Your Credit Score
Improving your credit score generally boils down to these four main steps:
- Pay all of your bills on time
- Keep your debt low, especially your credit card debt
- Don’t take out new debt if you don’t need it
- Keep your oldest credit cards open to establish a long credit history
3. Credit Reports
Your credit score is a number, but to calculate that number, the data comes from your credit report. Each of the three credit bureaus—Equifax, Experian and TransUnion—generates a credit report with historical data about your current and past debt obligations. Lenders look at your credit report to review specific details about your debts.
How to Check Your Credit Report
Credit reports can have errors on them, and sometimes that affects your credit score. So, it’s a good idea to check them occasionally to make sure they’re accurate, especially if you’re getting ready to apply for a big loan like a mortgage. You can check your credit report with each of the three bureaus through AnnualCreditReport.com. If you find any errors, be sure to fix them immediately.
You can typically only check your report for free once per year. However, during Covid-19, each credit bureau is offering free weekly credit reports until April 20, 2022.
4. Collateral
Some lenders require collateral—something of value, like your car, or house that secures the loan—to reduce the risk of default after lending you money. If you get a loan that requires collateral and you fall behind on your payments, the lender can repossess the item you pledged. This is common on car loans, for example. Your car serves as collateral, and the lender can repossess your car if you fail to repay.
How to Use Collateral
Taking out a loan with collateral can sometimes increase your creditworthiness. With personal loans, for example, you can generally find secured (i.e., with collateral) and unsecured (i.e., without collateral) loans. Opting for a secured loan makes you more creditworthy, although you will need to use a certificate of deposit (CD), savings account or something else of value as collateral.
For other types of loans, such as mortgages, home equity loans or home equity lines of credit (HELOCs), lenders typically always require collateral.
5. Down Payment Size
A down payment is an up-front partial payment for a large purchase, like a house or car. The bigger the down payment you make on a loan, the more skin you have in the game and the smaller the amount you’ll need to borrow. Lenders may also reward large down payments with lower interest rates.
How to Save Up a Down Payment
Saving up a down payment on something like a house can be a challenge. For mortgages, it’s recommended to save up to 20% of the purchase price to avoid extra private mortgage insurance (PMI) payments. But for a high-cost-of-living area, that sometimes means you need to save up a down payment that can be equivalent to buying an entire home outright in a lower-cost-of-living area.
It’s good to develop a savings plan so you can afford your goal. You can shorten this timeline by throwing any extra money you receive into savings, such as a tax refund, side hustle money or other windfalls.
6. Co-signers
Last but not least, adding a co-signer to your loan application can improve your creditworthiness. Co-signers help make the loan less risky for the lender because co-signers agree to repay the loan if you stop making payments. The lender will also evaluate their creditworthiness, which can help you receive more favorable terms.
How to Find a Co-signer
If you want to find a co-signer, start with a trusted friend or family member. Be sure the person understands the role of a co-signer and their responsibilities. It’s recommended that you have a written and signed plan in place for how you’re going to manage the loan.
If you choose to use a co-signer, it’s vital that you repay your debt obligations on time. Any late payments you make will hurt both you and your co-signer’s credit.
Raise Your FICO® Score Instantly with Experian Boost™
Experian can help raise your FICO® Score based on bill payment like your phone, utilities and popular streaming services. Results may vary. See site for more details.
Bottom Line
If you’re preparing to apply for a new loan or credit, or plan on doing so in the future, be sure to focus on improving your creditworthiness and building your credit. Not only will this increase your qualification chances, but it also will help you receive the most favorable terms possible, like low interest rates and larger loan limits.
