What’s The Rate?
May 5, 2005 by Doug Dunkelberg

The question asked most often of an individual or business owner seeking a loan is, “What’s the rate?” The answer is not as definitive as one might expect.

When granting a loan, the borrower’s ability to repay that debt figures heavily into the amount of risk that a financial institution is willing to accept. Therefore, the borrower’s credit history is an important factor in the interest that they pay on a personal or business loan.

Just as you would hesitate to lend money to a stranger, banks will not grant you credit without knowing something about you. When considering a loan application, banks and other financial institutions utilize the “Five C’s of Credit.” These are: Character, Capacity, Collateral, Capital, and Condition.

Character of the borrower is determined by a face-to-face interview, written facts at time of application, the borrower’s reputation in the industry and the borrower’s Credit Bureau report. The borrower’s ability and willingness to meet financial obligations, any negative credit history investigated, and proof of satisfied collection accounts also are considered in determining the ‘character’ of the borrower.

Capacity is the borrower’s debt-to-Income ratio or, stated differently, it’s the borrower’s ability to repay the loan. The lender determines the borrower’s total annual obligations divided by their total recurring annual gross income to calculate the debt-to-income ratio. This ratio gives an indication of the borrower’s capacity to repay the loan. This ratio generally should be in the range of 38% to 40%.

Collateral is equity in a borrower’s assets (i.e. car, boat, real estate or time certificate) that can be pledged to secure a loan. Collateral serves as a type of ‘insurance policy’ for the lender. It provides a secondary way for a bank to collect its loan in the event a borrower stops paying via liquidation of the collateral.

Capital is the calculation that provides information on the borrower’s net worth: Assets – Liabilities = Net Worth. Assets include liquid assets such as cash and deposit accounts, investments, stocks, bonds, mutual funds, and non-liquid assets such as real estate, consumer goods, cars (but not leased vehicles), boats, and recreational vehicles. Liabilities include mortgage payments, rent payments, equity loan payments, car payments (loan or lease), boat payments, credit cards, alimony, child support, and day care. The greater the extent that assets exceed liabilities, the better. Also, the more liquid the asset mix, the better.

Conditions considered by the lender are the indications of the overall stability or instability of the applicant: time on the job, time in residence, and for business owners, the length of time the business has been in operation and how stable the industry of that particular business is.

Credit scores can range from a low of 400+ to a high of 850. These scores are based on mathematical formulas developed by the credit bureaus. The final scores represent the likelihood of a borrower repaying a loan, and this likelihood increases with a higher credit score. Lenders often classify these credit scores as A, B, C, D and E; and often times these ratings can affect the interest rates that a borrower may be charged.

A borrower should regularly review their credit report and correct any errors. If your credit is substandard (below 640) work with your local banker to identify ways to improve your score. Most importantly, individuals and business owners should develop a relationship with their local bank and use their banker as a good financial resource to assure that they achieve the financial stability that they seek in both their personal and business affairs.

Doug Dunkelberg is a Senior Vice-President & Senior Loan Officer at Citizens State Bank, which was established in New Baltimore MI in 1922. Citizens State Bank is locally owned and operated, and specializes in serving small business owners in Macomb and St. Clair counties. Contact Doug at ddunkelberg@mycommunitybank.com or call him at 888.598.8900.

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