Enticed by the prospect of a sign-up bonus worth nearly as much as you earn in a week, you apply online for the travel rewards credit card you’ve had your eye on for months. You have a steady job that pays good money, so you figure you’re a lock for approval.
You’re not. After you submit your application, the credit card issuer informs you that they need more time to consider it. A week goes by with no word. Then you receive a businesslike letter saying your application has been rejected. Your credit score is 620, which sounds high but is actually not great, and your debt-to-income ratio exceeds 50%, which is too high for most lenders’ comfort.
Once the surprise wears off, you decide you need to learn more about what it means to be creditworthy. It’s the sort of knowledge that can really pay off, and as you soon learn, it’s not particularly difficult to understand.
What Is Creditworthiness?
Creditworthiness is a measure of the risk you present to lenders — the likelihood you’ll repay a loan on time and in full.
When determining your creditworthiness, lenders consider several crucial pieces of information:
- Your credit score, a three-digit number that approximates your risk as a borrower based on the information in your credit report
- Your payment history, the single most important component of your credit score
- Your debt-to-income ratio, which compares how much you owe your creditors with your gross income
- Other details in your credit report, such as the size of your credit balances, any past-due amounts, any accounts reported to collections agencies, and recent bankruptcies
Lenders may consider other factors that don’t show up on your credit report or in your credit score. For example, lenders often look at net worth and may be more likely to approve loans from applicants with hefty bank or investment account balances.
The 5 C’s of Creditworthiness
You won’t find them listed in your credit report, but the five C’s of creditworthiness play an outsize role in lenders’ underwriting decisions. Together, they support a holistic view of creditworthiness that you don’t need a finance degree to understand.
- Character. Your credit “character” is your credit history, or the sum of the information on your credit report. It encompasses your payment history, credit mix, delinquencies, bankruptcies, and other positive and negative credit-related factors. It’s summarized in your credit score (most often your FICO score).
- Capacity. Your capacity is your debt-to-income ratio. The higher your debt-to-income ratio, the less capacity you have to take on more debt. A debt-to-income ratio below 36% is ideal, but some lenders accept borrowers up to 43% or even 50%.
- Capital. Capital refers to the down payment on the loan, if any. Down payments are common (and often required) on major consumer loans, such as car and home loans. The larger the down payment, the less risk assumed by the lender.
- Collateral. Collateral refers to the asset or assets securing the loan, if any. Many loans are unsecured, meaning they’re not backed by any collateral. Secured loans are backed by collateral, such as a car or house. If you stop making payments on the loan, the lender has the right to seize and sell the collateral, which reduces their risk.
- Conditions. This is a catchall term for the specific circumstances around the loan, including noncredit factors specific to the borrower. That includes the purpose of the loan, the economic environment, the borrower’s employment status, the loan’s term length, and the loan’s interest rate.
Factors That Influence Creditworthiness
To truly understand what it means to be creditworthy, you need to understand three broad categories of factors that influence lenders’ decision-making processes: credit history and payment behavior, income and employment stability, and debt-to-income ratio.
Credit History & Payment Behavior
Your payment history is the most important of several factors that lenders consider when assessing your credit history:
- Payment behavior. Lenders like borrowers who pay their bills on time. Even one late payment can negatively affect your credit score. Multiple late payments spread across multiple accounts can be downright toxic.
- Credit utilization. Your credit utilization ratio is your current credit balances divided by your current credit limit. The more you’re borrowing as a proportion of your cumulative credit limit, the riskier you appear to lenders. Shoot for a credit utilization ratio under 30%.
- Length of credit history. If you don’t open or close any credit accounts, your credit score slowly improves with time. That’s because the longer you demonstrate your ability to responsibly use credit, the better lenders feel about extending a new loan your way.
- Credit mix. Lenders like it when borrowers responsibly juggle more than one type of credit. Making timely payments on five different credit cards is good, but making timely payments on five different credit cards, a mortgage, a car loan, and a student loan is even better.
- Recent credit inquiries. This factor considers how many credit accounts you’ve applied for in the past year or two. Pulling your own credit report doesn’t ding your score, but a lender inquiry does.
Income & Employment Stability
Income and employment are two related factors that have a big impact on your creditworthiness.
Your total income is important. More is better. But how you earn your income is even more important.
All else being equal, lenders prefer applicants who’ve held full-time, salaried jobs for at least two years. Two years is long enough to demonstrate that they can keep a job. And the salaried part is important because salaried workers are less vulnerable to pay cuts than hourly employees (especially part-time employees).
Self-employed applicants can still qualify for loans, but they may need to earn more overall than otherwise similar applicants with full-time salaried jobs. The same goes for business owners, though business owners who put up company assets as collateral may be able to get around strict income and employment requirements.
Other sources of income can positively affect creditworthiness as well. For example, if you have modest employment income but a hefty stock portfolio that throws off significant dividend income, you’re less risky than a coworker who’s not raking in passive income.
All lenders consider your back-end debt-to-income ratio, which measures your total debt balance as a proportion of your total gross income. The ideal back-end debt-to-income ratio is 36% or below, and lower is always better. Some lenders accept applicants with back-end ratios up to 50%, but that’s usually the upper limit.
Mortgage lenders and some other creditors also consider your front-end debt-to-income ratio, also known as your housing ratio. Your front-end ratio measures your total monthly housing costs (including taxes, insurance, and HOA fees if you own your home) as a proportion of your total gross income. The ideal housing ratio is under 25%, and 28% is the upper limit for conventional mortgages.
Establishing & Maintaining Creditworthiness
Now that you understand the factors that determine your creditworthiness, you’re ready to get to work. The three most important steps you can take to establish and maintain your creditworthiness are to build a positive credit history, manage your existing and future debts responsibly, and keep tabs on your credit over time.
Build a Positive Credit History
Building a positive credit history is harder than it sounds because many lenders avoid borrowers with limited or no credit. But there are ways to get around that, even if you’re starting from scratch, and it gets easier over time. Do the following:
- Add rent and utility payments to your credit report if possible. Most landlords don’t report rent payments to credit bureaus. So sign up for a rent-reporting service that does. You may need to pay a monthly fee, but you can cancel once your credit is on sounder footing.
- Apply for a credit-builder loan. A credit-builder loan is a type of installment loan for people with limited or no credit. It’s usually quite small, but what’s more important is that every on-time payment builds credit.
- Apply for a secured credit card. A secured credit card is another realistic option for new-to-credit borrowers. Having one alongside a credit-builder loan helps diversify your credit mix right out of the gate.
- Upgrade to an unsecured credit card. Many secured credit cards allow you to upgrade to an unsecured credit card, often with a higher credit limit, after six to 12 timely payments.
- Diversify your credit mix. As your credit score rises and your credit history lengthens, apply for different types of loans as you need them: student loans, car loans, home loans, and so on. This further diversifies your credit mix and supports your score.
- Keep your accounts open. Don’t close credit accounts unless you have to pay an annual fee to keep them open. Be especially careful about closing the oldest accounts, which disproportionately dings your score.
Manage Debt Responsibly
It doesn’t matter how many credit accounts you have, nor how diverse they are, if you don’t use them responsibly. Keep these ground rules in mind:
- Don’t apply for unnecessary credit. Every loan you apply for should have a clear purpose. Don’t apply for credit just to diversify your credit mix or lower your utilization. These things should happen naturally over time with responsible use.
- Keep your credit utilization ratio low. Don’t overspend on credit, especially credit cards. Absent emergencies, you should always pay off your credit cards in full each month.
- Always pay your bills on time. Remember, your payment history is the single most important component of your credit score (and, by extension, of your creditworthiness). Even one missed payment can have serious consequences.
- Avoid carrying high-interest credit card debt. Too much high-interest credit card debt can spark a vicious cycle that raises your credit utilization ratio and affects your ability to pay down other debts. It’s also really expensive. If you’re currently grappling with credit card debt, prioritize paying it down before progressing toward any other financial goals.
Monitor Credit Reports
Finally, keep close tabs on your personal credit. Credit reporting errors and fraudulent accounts are relatively rare, but they can have serious consequences when they do happen.
At the absolute minimum, take advantage of your legal right to receive one free annual credit report from each of the three major credit reporting bureaus (TransUnion, Experian, and Equifax). Spread these reports evenly throughout the year: for example, one in January, one in April or May, and one in September.
Review each credit report for unfamiliar accounts, like credit cards you don’t remember applying for. These could be fraudulent and may be a sign that someone has stolen your identity. If you see any, file a dispute with the credit reporting bureau and lock your credit to prevent additional fraud.
Review legitimate accounts as well to make sure that the creditor reported your payments and balances accurately and on time. If you see payment you know you made flagged as missing, dispute the entry.
Creditworthiness isn’t rocket science. It’s not even MBA-level jargon. It’s a straightforward concept that every adult can (and should) understand.
Once you have it down, put what you’ve learned to work. If you’re new to credit, take baby steps to build your credit history and increase your score, like applying for a credit-builder loan and secured credit card. Add new types of credit to the mix, taking care to keep your utilization ratio low and make on-time payments. And check your credit reports regularly to ensure no one’s doing anything funny with your good name.
Even if you do everything right, you might never achieve a perfect credit score. But you’ll have more opportunities than if you’d neglected your creditworthiness all along.