You can never tell when life will throw you a curveball. There might be instances when you are in need of emergency funds — where your current cash levels are not sufficient to cover the need at hand.
This could include the money that is needed for covering marriage or medical expenses, making a large purchase, consolidating an ongoing debt, or meeting any other expense for which you lack the necessary funds. At 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 going for a personal loan would be ideal.
Personal Lending: What You Need to Know
When there is a need for quick cash, going for a personal loan would be the best choice, considering how this option boasts of the quickest disbursal compared to other loans in the market. Given how easy it is to secure a personal loan, an update by the RBI in March 2021 stated that personal loans have recorded a 13.5% growth (Y-o-Y). This just goes on to show that more people are now relying on personal loans to cover unplanned expenses and in some cases, even to make ends meet.
Bear in mind, before the lender sanctions a loan, credit risk assessments come into the picture. Let’s understand more about credit risk assessment and the top factors that affect credit risk in personal lending.
Credit Risk: What is it All About?
To put it very simply, credit risk refers to the risk of loss that a lender faces due to a borrower’s failure to repay any type of loan or debt. In the personal lending space, the practice of credit risk assessment deals with ascertaining whether or not an individual should be awarded a certain amount of credit.
This process considers the risk that the lending party will have to bear in cases where the principal and interest of the loan amount will not be received.
With the onset of the pandemic and the credit crunch that followed, credit risk assessment has taken center stage for financial institutions. A process that most financial institutions find challenging, credit risk assessment is all about analyzing the bank’s capital and loan reserves at a time, in a bid to mitigate the losses that arise from bad loans.
With regulators demanding more transparency, the onus is on the banks to do a thorough background check of their customers and correctly arrive at the associated credit risk.
When it comes to personal lending, the challenge lies in correctly assessing whether or not an individual can honor the agreement of repaying the borrowed amount. The factors that are taken into consideration are — the loan amount, payment schedule and tenure of the loan.
While giving people better access to credit can prove to be beneficial to the economy as a whole, it’s important to assess the credit risk involved. When financial institutions fail to perform their due diligence and award loans without a proper credit assessment – then credit assets will end up becoming Non Performing Assets (NPAs), resulting in major losses to the lending institutions and eventually to the overall economy.
Key Factors Affecting Credit Risk in Personal Lending
It’s important to understand what factors are taken into consideration by the lender when evaluating personal loan applications.
Credit risk assessment impacts the interest rates significantly. In cases where high credit risk is associated with a borrower — higher interest rates are demanded by the lender for the capital that is provided. If the risks assessed are too high, then banks and lending institutions can also choose to decline the loan application.
There are five top factors or more popularly known as the ‘5 Cs’ of credit risk that are measured. When banks, NBFCs and other financial institutions are screening loan applications, they take into account these 5 C’s in estimating the creditworthiness of the borrower and the risks associated with lending a loan. These five factors not only help lending institutions in quantifying and deciding the eligibility of a loan applicant but also help in determining the interest rates and credit limits for borrowers.
The 5 C’s that are used to determine a borrower’s creditworthiness are:
1. Capacity
The borrower’s capacity to repay the loan is the most important of the 5 factors. For personal lending, the customer’s employment history, current job stability and income amount are all key indicators of the borrower’s ability to repay the outstanding debt. A well-balanced income and expenditure relationship not only reflects the borrower’s financial capacity but also his ability and prudence in the management of affairs.
For instance, borrowers with college-bound children or entrepreneurs of small businesses with unsteady cash flows, are considered to be ‘low capacity’ borrowers.
To determine whether the borrower will be able to generate the required money to repay the loan — the ‘Debt-to-Equity’ ratio comes into the picture. The borrower’s ability is estimated by comparing current income (before taxation) against recurring debts.
2. Capital
This factor is all about assessing the net worth of the individual who has applied for a loan. It represents the number of assets that belong to the borrower and it could range from savings and investments to even assets like jewelry.
A good capital rating would indicate that the borrower is adequately capitalized to bear any unexpected losses.
While the current income amount is used to repay a personal loan, the borrower’s capital is considered to be an additional reserve to meet needs, should there be any unforeseen circ*mstances.
3. Conditions
When it comes to ascertaining the risk the lender will have to bear, considering external factors — such as economy, market and industry conditions are also important as they will have an indirect bearing on the borrower’s capacity to repay the loan.
The objective here is to determine if the borrower will be able to adapt to changing conditions and be flexible enough to repay the loan throughout its tenure.
4. Collateral
Collaterals refer to the assets of the borrower that may be pledged under their name, as a security for the credit that is extended. This could include fixed assets like the title of land that belongs to the borrower and even financial assets like bonds.
Collaterals are only pledged for secured loans and not for unsecured loans like credit cards.
What we need to understand here is that collaterals will not be used to determine the capacity of a borrower. This is because collaterals are only liquidated in worst-case scenarios when the borrower fails to repay the loan.
5. Character
Character is all about the borrower’s moral integrity — it all comes down to the borrower’s willingness to repay the loan. It assesses whether or not the borrower will honor the credit obligation.
Character is by far the most comprehensive aspect of evaluating the borrower’s creditworthiness. The borrower’s history of repayments and managing credit is analyzed to determine the borrower’s propensity for repaying the loan. If there are indications of defaults, this simply shows that the borrower has been negligent or irresponsible in the past. This could imply a negative trait of character which will then result in lower ratings.
Why are the 5 C’s Important?
The 5 C’s provide a basic structure for credit risk assessment. They are not only crucial in laying out a framework but also help in setting objectives that will, in turn, enable lending institutions to determine the borrower’s eligibility to receive a loan.
Credit risk departments across lending institutions are invested in making data-driven decisions — and the 5 C’s of credit risk help them arrive at accurate estimations about the borrower’s creditworthiness.
There are no strict rules by which lenders give weightage to these attributes — different lenders may value one attribute over the other. Online lending portals may give weightage to character and capacity whereas banks feel collaterals are most important.
Along with these 5 factors of credit risk assessment, in some cases, credit scores are also considered to screen loan applications. Having said that, what the credit risk and credit score mean and how they can impact the lending process can be confusing.
Credit Risk Assessment Vs Credit Score
Both credit risk and credit score are similar in many ways as they both are used to measure the borrower’s credibility. This explains why they end up being used interchangeably!
Let’s put all the confusion to rest by first understanding what credit score is and then moving 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 when it comes to a personal loan, credit scores not only impact loan approval but also have a bearing on the interest rates.
It is a number that lenders arrive at by analyzing the customer’s repayment history and other credit details like utilization of credit and tenures of previous debts across different types of loans and lending institutions.
This numerical score helps lenders assess the probability of debt repayment on the customer’s part. A credit score is a 3-digit number ranging from 300 to 900. Typically the higher the credit score is, the higher will be the financial trustworthiness of that customer. Ensuring that you make timely repayments against your loan will increase your score, whereas defaulting payments and delaying them would adversely affect your score.
Any score above 750 is considered to be a good credit score and this allows you to secure loans at lower interest rates. Factors like credit history, credit utilization and duration along with miscellaneous factors such as the number of loan applications that have been made in the past, can impact your credit score.
Difference Between Credit Risk and Credit Score
While both credit risk and credit score are affected by past credit history, the primary difference is that credit risk provides a much broader scope of evaluating a customer’s trustworthiness. Credit risk assessment takes into account a lot more factors as we’ve seen earlier and is thereby, considered to be more comprehensive and provides a better understanding of the borrower’s creditworthiness.
This is why financial institutions are now starting to give prominence to credit risk assessment while screening loan applications. Credit risk assessment has also become a key decision-making factor for large loans such as mortgages.
Bottom Line
While credit score is still being used as a deciding factor in loan application evaluations, many of the new-age FinTechs and lending portals prefer not to just rely on credit scores and are looking to take on a broader approach.
In many ways, it’s safe to say that credit risk assessments are now replacing credit scores when it comes to evaluating the customer’s borrowing and repayment capabilities.
