The decision to lend a prospective borrower money is rarely taken lightly. After all, what if the borrower fails to repay the loan? Lenders are in business to make money through interest payments and cannot afford to decline every loan opportunity. In order to minimize the risks associated with lending, lenders examine the applicant's credit history and use other criteria to make educated decisions about the applicant's ability to repay the loan. This process involves conducting a credit risk analysis.
To conduct your own basic credit risk analysis, it's smart to use software designed specifically for the task. In general, basic credit risk analysis examines the following:
· Borrower reliability - This involves finding out how reliable the applicant has been in the past as far as paying bills on time and credit histories go. Other factors affecting reliability could also include work histories and length of time living in one place. In order to determine reliability, look at credit reports and check references.
· Ability to pay - Next, it's important to determine if the applicant has the means to pay back the loan, both on a monthly payment basis and for the long-term. Does the applicant have a job? How much does it pay? Is the job secure? In addition to looking at the applicant's ability to generate revenue, either via a job or a business, determine if the applicant has sufficient reserves should revenue fall short.
· Economic conditions and industry trends - Economic conditions and industry trends can influence credit risk. For example, if a business loan applicant is in a booming industry with a rosy long-term outlook, that applicant will be less risky than one in a depressed industry with minimal demand for products and services.
· Collateral - Another factor in determining credit risk is whether or not the loan is secured or unsecured. Backing up a loan with assets (collateral) means that should the borrower default on the loan, the lender has recourse and can recover a portion of its losses through the liquidation or foreclosure process. With an unsecured loan, this is not an option. Some lenders will issue secured loans to those deemed a poor credit risk because the borrower has something at stake.
· Down payment - How much is the applicant willing to put down as a down payment? This is similar to collateral in that the more the applicant puts down, the more there is at stake. For example, a borrower with $100,000 invested in a $200,000 loan has far more at stake than one with zero down. Thus, the heavily invested borrower is less likely to walk away from the loan.
These are important factors that can indicate whether or not a potential borrower is a good credit risk. Using software can quantify this information, create a borrower scorecard, and compare the results against pre-determined benchmarks and loan product pricing. By conducting basic credit risk analysis, you can get a better understanding of the level of risk for each borrower, make smarter lending decisions, and tailor your loan products to match the risks you take.
