Creditworthiness

Meaning of Creditworthiness

Creditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money.

Creditworthiness applies to people, sovereign states, securities, and other entities whereby, before getting a new loan, the creditors will analyze your creditworthiness.

Key Takeaways
  • Creditworthiness is a grade for an individual, security, or sovereign states that evaluates the entities’ ability to pay and accrue debt.
  • There are five criteria of evaluation that lenders use for individuals and businesses: capacity, capital, conditions, character, and collateral.
  • The three biggest credit rating agencies for securities and sovereign states are Moody’s, Standard & Poor and Fitch.

Creditworthiness for Individuals

Creditworthiness

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Creditworthiness for individuals is evaluated based on several factors. Typically, lenders will take a qualitative and quantitative look at the 5 C’s of Credit when evaluating a borrower: capacity, capital, conditions, character, and collateral, which are detailed below:

#1 – Character

This part judges the background of the borrower. As such, the creditor will evaluate the borrower’s educational and employment background. It is a way to learn about an individual’s ethics and personal conduct. For example, a swindler’s character assessment will talk about the lack of integrity.

#2 – Capacity

Here, it is determined whether the individual has a steady income to be able to pay the instalments and interests. Whether they’d have enough savings left after paying their expenditure to arrange for their debt obligations. The creditors are also interested in learning about the source of the cash with which the borrower will repay the loan. They’d try to determine if the source of cash will be reliable enough to help them honor their debt obligations.

For this, the creditors will also evaluate the potential borrowers’ credit history using their credit scores. A credit score defines a person’s creditworthiness using the numbers ranging from 300-850. Usually, a credit score between 670-739 is considered a sound score.

The lender will also evaluate the borrower’s current credit utilization rate (percent of credit card debt currently being used) and total debt service to incomeDebt Service To IncomeThe debt to income ratio (DTI) measures the borrower's potential to clear the liabilities (payable in installments) from the monthly income. It is computed as a percentage of monthly debt payments to the gross monthly income. The lower the ratio, the higher is the borrower's repayment capability.read more.

#3 – Capital

Suppose a woman has approached a bank to borrow some money for starting a snack delivery business out of her home. If the bank learns that the woman has already invested a good deal of her personal finance into her small business, it will boost its confidence in the borrower.

Having some form of monetary interest at stake not only makes a borrower appear as a party who would make good use of the borrowed funds, but it also obligates the borrower to be successful if they aren’t planning on losing their money. This helps to strengthen the borrower’s case.

#4 – Conditions

Lenders will look into the reason for acquiring the loan. A lender will usually request for a reason for a loan, which could be to purchase a house. Apart from the borrowers’ own financial conditions, the creditors look for reasons not related to them.

These could be the political-economic conditions of a country. If a country is in recession with interest cuts and job losses, it will weaken a borrower’s case.

#5 – Collateral

What is the borrower pledging in assets as a security for this loan? The easiest example is when lenders have the ability to foreclose upon a property if a property owner is unable to make their payments. Several studies have been conducted to understand the requirement of pledging an asset as a security against a loan.

Lenders often look for secured loansSecured LoansA secured loan is one where the borrower pledges his/her assets as a collateral to the issuer as a security. In the event of nonpayment of the loan, the issuer has the right to sell or transfer the secured property in order to recover the balance owed.read more or guarantees, especially in the case of high-risk borrowers. A high-risk borrower has a greater chance of defaulting. Besides, they also charge higher rates of interests from such a group to compensate for the greater risk. The factors for judging a company’s creditworthiness are the same as above, but the analysis is done concerning the business.

Creditworthiness for the Sovereign States

A state cannot exert its own rating on the financial or political risk to invest in its debt instruments. Sovereign states will receive a Sovereign Credit Rating, which is an independent evaluation.

A third-party credit rating agency will give a rating to a country judging its economic and political risksPolitical RisksPolitical risk is defined as a risk that emerges as a result of a change in a country's governing body, posing a risk to investors in financial instruments such as debt funds, mutual funds, and equities.read more. A mounting budget deficitBudget DeficitBudget Deficit is the shortage of revenue against the expenses. The budgetary deficit could be the sum of deficit from revenue and capital account. read more will degrade a nations’ creditworthiness. For example, in 2011, popular credit rating agency, S&P reduced the credit rating of the U.S. to AA-plus due to the case of a mounting budget deficit and debt liability. The move had affected the investors’ trust in the state, especially since it had been holding S&P’s AAA rating since 1941.

A low credit rating reflects low creditworthiness of a nation that could prevent them from raising money from the global market and bodies. The top three credit rating agencies are Standard & Poor’s, Moody’s and Fitch. The S&P will give a BBB or higher rating to countries that they consider less risky for investment. Moody’s calls this same lower level of risk a Baa3 rating.

Creditworthiness of Securities

Securities are just financial instruments to raise funds in capital marketsCapital MarketsA capital market is a place where buyers and sellers interact and trade financial securities such as debentures, stocks, debt instruments, bonds, and derivative instruments such as futures, options, swaps, and exchange-traded funds (ETFs). There are two kinds of markets: primary markets and secondary markets.read more. The three types of securities are equityEquityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company's balance sheet.read more, debt, and hybrid of the two. Just like lenders judge the creditworthiness of a company, securities are also put through this test. The securities are also evaluated with credit ratings. Securities’ credit ratings are a financial indicator of the success and strength of the security.

Moody’s, the S&P, and Fitch all assign credit ratings to bondsRatings To BondsBond rating refers to how designated agencies classify fixed income securities in order to help investors identify the security's future potential. After researching the issuer's financial standing, including growth prospects and upcoming corporate actions, ratings are assigned.read more and companies. These three agencies evaluate over 95% of the rating business and are registered with the SEC. There are two parts of the grade: the score itself and an evaluator that describes the future credibility of the security (such as likely to upgrade or likely to downgrade for Moody’s designation).

This has been a guide to Creditworthiness and its Meaning. Here we discuss how to evaluate creditworthiness for individuals and businesses along with the sovereign states. You may also have a look at the following articles to learn more –