Every financial institution sets its own criteria for approving applications for credit lines. While specific guidelines vary, credit decisions ultimately come down to risk versus reward. Banks weigh the potential earnings on a credit line against the risk of borrower default. You improve your chances of getting approved for a line of credit if you can demonstrate your creditworthiness. Banks assess creditworthiness by using the so-called Five C's of credit.
Lines of Credit basics
Credit lines are open-ended loans often with variable rates that you can draw upon and repay numerous times. Unlike car loans or mortgages, lines of credit have no fixed payments or specific end dates. Monthly payments are often interest only, which suits borrowers with limited cash flow. If you make no principal payments, however, you never reduce the debt and this exposes your lender to an increased level of risk when compared with loans requiring monthly principal and interest payments. Additionally, credit lines often have variable rates attached to the prime rate. Your payments can fluctuate enormously over the course of time.
In the lending arena, capacity refers to your financial ability to repay a loan or line of credit. Lenders use a formula called a debt-to-income ratio to determine your financial strength. This involves dividing your existing monthly debt payments into your gross monthly income. Credit line payments fluctuate based upon use. If you have a zero balance, then you make no payment at all. For underwriting purposes, lenders typically calculate the DTI ratio based upon the maximum payment you could incur. The lower your DTI, the better your chances of obtaining a loan.
Paying down credit cards and credit lines won't help your DTI since lenders calculate your DTI based on the line amount rather than the balance owed. You can reduce your debt load by paying off debts with fixed payments such as car and installment loans.
The U.S. Department of Commerce's Minority Business Development Agency defines character as "the general impression you make on the prospective lender or investor." Lenders will base your creditworthiness on factors such as your educational background, work history and credit history. Your credit history reflects loans and credit you have received in the past and covers balances owed, payments made, delinquencies and credit scores. The three major credit bureaus -- Equifax, Experian, and TransUnion -- all award credit scores ranging from 300 to 850. According to Experian.com while most people have scores falling between 600 and 750, a score over 700 is good. Balances on revolving debt such as credit cards have an effect on your score. You improve your score if you pay down revolving debt while high balances can cause your score to plummet. Late payments and other derogatory items can hurt your score.
Conditions are potentially the most problematic of the 5 C's of credit because they are influenced by certain factors that are out of your control. The bank must decide if the conditions are right for approving your line of credit. In times of recession, banks curtail lending. This makes credit hard to obtain even for the most creditworthy customers. A bank with a huge portfolio of credit lines might feel the conditions are not right for taking on more exposure to that type of debt even if you seem like a great borrowing candidate. The purpose of the loan normally has an impact on the conditions discussion, but this doesn't so much apply to lines of credit as you can typically use the line for any legal purpose.
Capital is a consideration in any underwriting decision as lenders want to see how much cash you have on hand. If you were to lose your job, do you have cash resources to pay your bills, or would you be entirely reliant on the line of credit? Moreover, if you would need the credit line to pay your bill, then how would you repay the line of credit? You improve your chances of accessing credit if you save up some cash in your bank. However, don't tie up all of your money in illiquid assets such as annuities that you can't easily access in case of emergency. Banks are interested in the capital you can easily access rather than long-term investments that bolster your net worth.
Some lines of credit, such as equity lines, are secured to property such as real estate. This means the bank has some recourse in the event that you default on your debt. You can also attach credit lines to cash held in bank accounts and brokerage accounts. The collateral increases your chances of approval because it reduces the bank's chances of incurring a loss if you don't repay the debt. Even if you apply for unsecured credit, your assets could play a role in the underwriting process. For example, if you fail to pay off an unsecured debt, a bank could potentially ask a court to place a lien on your home or your car until you have settled the debt. If you have lien attachable assets, you improve your chances of qualifying for even unsecured debt.
You can overcome issues relating to lack of capital, credit or capacity by adding a creditworthy cosigner to your loan. Make sure the cosigner understands that you both are equally liable for repaying the debt.
The five C's of credit exist to protect both you and your lender. If you lack the capacity, credit or capital to take on an unsecured line then it's advisable to work on improving your financial situation before attempting to take on more debt. It's illegal to mislead a lender about your financial circumstances in order to qualify for credit.