5 Key Factors That Affect Credit Risk Assessment
5 Key Factors That Affect Credit Risk Assessment

5 Key Factors That Affect Credit Risk Assessment

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You can never tell when life will throw a curveball in front of you. There may be instances when you need an emergency fund, where your current cash level is not enough to meet an existing need. This may include money that is needed to cover marriage or medical expenses, make large purchases, consolidate ongoing debt, or meet any other expenses for which you lack the necessary funds. At such times, it is wiser to borrow money. Although there are plenty of loan options to choose from, let’s find out why taking a personal loan would be ideal. Take the guesswork out of credit risk assessment with AI.

Personal Lending: What You Need to Know

When quick cash is needed, taking a personal loan will be the best option, considering that this option boasts the fastest delivery compared to other loans in the market. Given how easy it is to secure personal loans, an RBI update in March 2021 states that personal loans have registered a growth of 13.5% (year-on-year). This suggests that more people are now relying on personal loans to cover unplanned expenses and in some cases, even to meet their needs. Keep in mind, before the lender approves the loan, the credit risk assessment comes into the picture. Let’s understand more about the top factors affecting credit risk in credit risk assessment and 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 must incur due to a borrower’s failure to repay any type of loan or loan. In the field of personal lending, the practice of credit risk assessment is concerned with ensuring whether a certain amount of credit should be granted to an individual.

This procedure 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 subsequent debt crisis, debt risk assessment has taken centre stage for financial institutions. A process that most financial institutions consider challenging, credit risk assessment is about analysing the bank’s capital and debt reserves at one time, to minimise losses from bad loans.

Key Factors Affecting Credit Risk

It is important to understand what factors the lender takes into account when evaluating personal loan applications. Credit risk assessment has a significant impact on interest rates. In cases where high credit risk is associated with the borrower, higher interest rates are demanded by the lender for the capital provided. If the assessed risks are too high, banks and lending institutions may also choose to reject the loan application.

Capacity

The borrower’s ability to repay the debt is the most important of the 5 factors. For personal lending, the client’s employment history, current job stability, and income amount are all key indicators of the borrower’s ability to repay outstanding debt. A well-balanced income and expense relationship reflects not only the financial capacity of the borrower but also his competence and prudence in managing affairs.

For example, borrowers with college-going children or entrepreneurs from small businesses with unstable cash flows are considered borrowers with ‘low potential’. To determine whether the borrower will be able to generate the money needed 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 loans.

Capital

This factor is about assessing the net worth of a person who has applied for a loan. It shows the number of assets of the borrower and can range from savings and investments to assets such as jewelry. A good capital rating will indicate that the borrower has enough capital to bear any unforeseen losses. While the current income amount is used to repay a personal loan, the borrower’s capital is considered an additional reserve to meet the needs if there are any unforeseen circumstances.

Conditions

When it comes to finding out how much risk a lender will incur, it is also important to consider external factors such as economy, market, and industry conditions as they will have an indirect effect on the borrower’s ability to repay the loan. The objective here is to determine whether the borrower will be able to adapt to changing conditions and be flexible enough to repay the loan during the entire tenure.

Collateral

Collateral refers to borrower’s properties that can be pledged under their name, as security for extended loans. This can include fixed assets such as the borrower’s ownership of land and even financial assets such as bonds. Collateral is only pledged for secured loans, not unsecured loans such as credit cards. Here we need to understand that collateral will not be used to determine a borrower’s ability. This is because the liquidation of the collateral is only done in the worst case when the borrower fails to repay the loan.

Character

The character is entirely about the moral integrity of the borrower, it all depends on the borrower’s willingness to repay the loan. It assesses whether the borrower will comply with the loan obligation. Character is by far the most comprehensive aspect of evaluating a borrower’s creditworthiness. The borrower’s repayment history and debt management are analyzed to determine the borrower’s propensity to repay the loan. If there are signs of default, this directly indicates that the borrower has been negligent or irresponsible in the past. This can mean a negative quality of the character which will result in a lower rating.

Credit Risk Assessment Vs Credit Score

Both credit risk and credit score are similar in many ways as they are both used to measure a borrower’s credibility. This explains why they are used interchangeably!

Let’s first clear up all the confusion by understanding what a credit score is, and then move on to the difference between these two concepts.

What is a Credit Score?

The credit score is an indicator of the customer’s creditworthiness. This numerical score plays an important role in the lender’s decision to offer the loan amount. Here you need to understand that when it comes to personal loans, credit score not only affects loan clearances but also affects interest rates. It is a number that lenders reach by analyzing the repayment history of the client and other credit statements such as the use of the loan in different types of loans and lending institutions and the duration of previous loans.

This numerical score helps lenders assess the possibility of loan repayment on the client’s behalf. Credit scores range from 300 to 900, a 3-digit number. Usually the higher the credit score, the higher the financial credibility of that customer. Ensuring that you make timely payments against your debt will increase your score, while defaulting on payments and delaying them will adversely affect your score. Any score above 750 is considered a good credit score and it allows you to secure loans at low interest rates. Factors such as credit history, credit usage, and duration as well as diverse factors such as the number of loan applications made in the past can affect 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 wider scope for evaluating customer reliability. Credit risk assessment takes into account a lot of factors as we have seen before and thus, it is considered more comprehensive and provides a better understanding of the creditworthiness of the borrower. This is why financial institutions are now beginning to give prominence to credit risk assessment when examining loan applications. Credit risk assessment has also become an important decision-making factor for large loans such as mortgages.

Conclusion

While credit scores are still being used as a deciding factor in loan application valuation, many new age sunshine and lending portals prefer not to rely solely on credit scores and want to take a broader approach. In many ways, it’s safe to say that credit risk assessment is now replacing credit scores when it comes to evaluating a customer’s borrowing and repayment capabilities.

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