Applying for Credit

When you are ready to apply for credit, you should know what creditors think is important in deciding whether you are creditworthy. You should also know what they cannot legally consider in their decisions. The Equal Credit Opportunity Act (ECOA) starts all credit applicants off on the same footing. It states that race, color, age, sex, marital status, and certain other factors may not be used to discriminate against you in any part of a credit dealing.

When a lender extends credit to its customers, it recognizes that some customers will be unable or unwilling to pay for their purchases. Therefore, lenders must establish policies for determining who will receive credit. Most lenders build their credit policies around the five Cs of credit: character, capacity, capital, collateral, and conditions.

• Character. By character, we mean your attitude toward your credit obligations. Lenders often see this attitude as the important factor in predicting whether a borrower will make regular payments and repay the loan on time. In judging a borrower's character, the following items are considered: Is the borrower prompt in paying bills? Have other lenders had to dun the borrower with overdue notices before receiving payments? Have lenders been forced to take the borrower to court to obtain payments? Has the borrower ever filed for bankruptcy? If so, did the borrower make an attempt to repay the debts voluntarily?
• Capacity. By capacity, we mean your financial ability to meet credit obligations, that is, to make regular loan payments as scheduled in the credit agreement. The lender checks your salary and outstanding financial obligations before credit is approved. For example, the lender wants to know your occupation, how long you have worked, and how much you earn. The lender also wants to know your expenses, how many dependents you have, and whether you pay or receive alimony or child support.
• Capital. This refers to your assets or net worth. The greater your capital, the greater your ability to repay the loan of a specific size. Information on net worth can be obtained by requiring that you complete a credit application. You must also authorize employers and financial institutions to release information to confirm the claims made in the application.
• Collateral. For large amounts of credit, and especially for large loans, the lender may require some type of collateral. Collateral is a valuable asset pledged to assure loan repayment and is subject to seizure upon default. That means, if you fail to live up to the terms of the credit agreement, the collateral can be sold to pay off the debt.
• Conditions. The term "conditions" refers to the general economic conditions that can affect your ability to repay a loan or other credit obligation. The basic question of conditions focuses on the security of both your job and the company for which you work.

Creditors use different combinations of the above facts to reach their decision. Some creditors set unusually high standards, and other simply do not make certain kinds of loans. Creditors also use different kinds of rating systems. Some rely strictly on their own instinct and experience. Others use a credit-scoring or statistical system to predict whether you are a good credit risk.

Small business owners often have more trouble than employees in obtaining personal credit. One of the reasons for this is that creditors may feel that the income stream from a small business is less secure than income received as an employee. Also, the creditors may worry about verifying the amount of income actually generated by the small business.

Faced with these difficulties in obtaining credit, some small business owners may be tempted to "fudge" their income numbers, that is, inflate the amount received from their businesses. Such "creative accounting" is ill-advised: not only can a loan be denied if untrue information is supplied, but the applicant be criminally prosecuted.