How Do Lenders Measure Your Credit Risk?

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Lenders consider more than just your credit score. The 5 C’s of credit measure your credit risk.

Taking out a loan can be a nerve-wracking process, especially if you are refinancing an existing loan.

A common reason for refinancing a loan is because you’re struggling to make your current monthly payments. So, you may be anxious about how your track record with your previous lender will affect your chances of finding a new lender willing to give you better loan terms.

What can help take some of the stress away is understanding how a lender measures your level of risk, and taking action to improve your lending weak spots.

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How Do Lenders Determine My Credit Risk?

When it comes to approving borrowers for a loan, people are often surprised to learn that lenders look at more than just a potential borrower’s FICO® Score. The reason being that your FICO® score, a three-digit number that reflects the information on your credit reports, only reflects part of your lending history.

While you may be able to find some online lenders that will approve you based on a hard credit pull alone, lenders usually want to see a full credit risk assessment before approving you for a loan.

To separate low-risk borrowers from high-risk borrowers, lenders evaluate credit risk using five key factors. These factors are commonly referred to as the 5 C’s of credit: character, capacity, capital, collateral, and conditions.

1. Character

Your character is one of the first things that a lender will notice about you, especially if you are working with an in-person loan officer. Lenders want to know that the person that they are loaning money to is trustworthy, creditworthy, and easy to work with. If a hopeful borrower already has a positive relationship with the financial institution, this is likely to play in their favor.

To measure your character, lenders will refer to your credit rating, credit history, work experience, reputation within the community, credentials you may hold, and character references. If you are refinancing a loan, a new loan issuer will be especially curious about how you stand with your loan’s current lender.

2. Capacity

When considering your capacity, lenders are interested in your debt-to-income (DTI) ratio (a.k.a the amount of debt that you have vs. your income). Since a new loan will increase your debt-to-income ratio, lenders want to make sure that you have enough money to comfortably pay back a new loan on top of your existing debt obligations. If your DTI is high, it is likely that lenders will see this as a high risk factor.

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3. Capital (a.k.a cash flow)

When lenders look into your capital, they are looking to see if you have enough cash flow to cover the cost of the loan should your household income not be enough. To measure how much you have, lenders will ask you about the amount of money in your savings, investment holdings, and liquid assets.

4. Collateral

Lenders try their best to prevent lending to people who aren’t able to pay back their loans, but sometimes they mistake a high-risk borrower as a low credit risk. To ensure that they will still get paid, even if they do underestimate your risk of default, they will often require borrowers to pledge assets as collateral.

Assets that may be accepted as collateral include:

  • Real estate
  • Cash
  • Investment accounts

If the borrower defaults, meaning they don’t make their loan payments, the lender will take ownership of the asset provided as collateral in order to recoup their losses. Oftentimes, especially with auto loans, the asset held as collateral is the one that you are purchasing. So, if you default on your car loan, your lender will repossess your vehicle.

5. Conditions

Out of the 5 C’s, condition is often the factor that is out of a potential borrower’s control. Instead of evaluating you, lenders look at how outside factors could affect a borrower’s ability to pay back a new loan. Often when reviewing conditions, lenders are looking at the overall state of the economic world and the terms of the loan, like the interest rate and the repayment term.

What Should Potential Borrowers Expect When Applying for a Loan?

When you submit a loan application, you can expect to follow a similar process each time, even if each individual lender’s process has a couple of quirks. Usually, hopeful borrowers can expect the process to go something like this:

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Comparing quotes from multiple different lenders, or rate shopping, helps you secure the best rates and loan terms. If you don’t do it, you could miss out on more favorable terms, like a lower interest rate or loan term that is more suitable for your finances. Shopping through a marketplace can save you time and some serious cash.

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Provide financial information to your lender

Before a lender can assess your creditworthiness, they need to gather personal and financial information from you. To help this process along, you should prepare your financial statements ahead of time and locate any needed personal documents.

Depending on the types of loans you’re applying for, and the requirements specific to your lender, this information will be different. To obtain it, you will want to ask your potential lender directly.

Typically, at least the following will be requested:

  • A photo ID
  • Your social security number
  • Proof of income (paystubs, W-2’s, and 1099’s)
  • Proof of employment
  • Bank statements
  • Tax records
  • Investment summaries
  • Credit reports

Loan goes into underwriting

The underwriting process is designed to help loan companies make lending decisions based on the credit risk of potential borrowers. Using the 5 C’s of credit, your potential lender will review your creditworthiness and officially decide whether or not granting your loan is worth the risk.

If you are refinancing a vehicle, an underwriter is going to want to know about more than just the 5 C’s of credit. They will also want to know about the value of the asset (a.k.a your car). To make sure they don’t grant a loan with a high probability of default, they will ask you for at least the following:

  • Your vehicle’s make, model, and year
  • Your vehicle’s condition
  • Proof of auto insurance
  • Your vehicle’s VIN number

If approved, you close on your new loan

During the closing process, you can expect to sign all of the paperwork necessary for your loan, either physically or digitally. At this time, you may be responsible for making a down payment.

Once completed, the loan funds will either be deposited in your account, given to you as a check, or sent directly to whoever you are purchasing your asset from.

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How To Find Auto Refinance Loans as a High-risk Borrower

When you are a high-risk borrower, finding an auto refinance loan can be daunting. Afterall, you are likely already in negative standing with your current lender and worried about how a new lender will evaluate your credit risk.

However, even high-risk borrowers have options, although they are likely to come with higher interest rates. Here are a few:

Shop around

High-risk shoppers are not likely to be approved for the best loans (perhaps due to a bad credit score), but that doesn’t mean that they won’t be approved for any.

Potential borrowers will want to compare as many loans as possible in order to find the biggest pool of potential lenders. Even high-risk borrowers can find some variety in loan terms and lock in the best of the loan terms offered to them.

Lower your credit risk

Lowering your credit risk is hard to do overnight — if not impossible. It takes discipline and a willingness to dedicate change to improving your financial health.

So, how can you lower your credit risk? Here are a couple of tips:

  • Prioritize paying off your debt: Consistently making on-time debt payments lowers your debt-to-income ratio and improves your payment history. If you are behind on making loan payments, this is particularly important.
  • Increase your cash flow: Increasing your cash flow by doing things like getting a second job and cutting back on your monthly expenses can, over time, increase your credibility to lenders, since it will improve the chances of you being able to pay back the loan.
  • Dispute errors on your credit report: Every year, American’s are able to pull their credit report from each of the major credit bureaus (TransUnion, Equifax, and Experian) once for free. You can easily do so by requesting them through AnnualCreditReport.com. Once you receive yours, look over them, and make sure that there are not any errors. If you find one, it could tank your creditworthiness, so dispute any errors on your credit report as soon as possible.
  • Focus on the factors you can control: Focusing on the factors you can control, like your character, capacity, and cash flow will get you further in your lending journey than dwelling on ones that you can’t. For instance, if you are looking to refinance an auto loan, you cannot change the age or model of the car you financed, so the terms will still be affected by these factors no matter what you do.
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About The Author


Micah Murray

Micah Murray is a personal finance writer who has written for Money Under 30, ChooseFi, Leverage Rx, and others. He lives in Maine with his husband, their three cats, and their dog. In his spare time, you can find him around a campfire listening to a true crime podcast.


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