Chapter P5, Problem 1RQ

To determine

The criteria that a creditor uses to evaluate a potential borrower

Explanation of Solution

A creditor uses the following criteria of 5C character, capacity, capital, collateral, and conditions to evaluate a potential borrower:

1. Character: It shows a person’s reputation about the credit history through which the creditor can track previous record such as bankruptcies and determine the expected behavior of the borrower in future to repay the loan. This will help the creditor to know the credit risk.
2. Capacity: Under this way, a creditor can compare income and recurring debts by adding the borrower’s total monthly installment or debt payments to borrower’s gross monthly income. It provides the creditor a clear information whether it is possible for the borrower to repay the payment.
3. Capital: The information about capital of the borrower also helps the creditor to know the potential of the borrower to repay the loan as if borrower has a large capital contribution, then there are less chances of default.
4. Collateral: By repossessing the collateral, it is possible for the creditor to get back the proportion of the loan as it provides assurance to the creditor if the borrower defaults the loan payments.
5. Conditions: The general conditions which relate to the loan such as length of time up to which the borrower will be employed at his/her current job and the performance on the job, etc. help the creditor to know how successfully a borrower can repay the loan.

Economics Concept Introduction

Introduction: A credit score represents a person’s numeric information about the history of credit payments in the credit report that shows how likely a person can repay the loan. A creditor can use this information to lend money to the borrower.