Financial institutions such as banks, credit unions, and personal loan lenders will always assess the amount of risk that an individual possesses before they will extend them credit. Risk is the likelihood that a business or consumer will default on a loan. Sometimes risk analysis is done on the merits, knowledge and experience of a loan officer. He compiles all of the pertinent information about a borrower such as his income, credit history, income, and his stability.
A lending officer will gather all of the information and then if he has further questions he will in most cases contact the borrower directly to see if he can get his questions answered. Sometimes it will be about his income.
Perhaps the income is from commission or maybe it’s seasonal. The lending officer will want to know all the information he can possibly gather because the more information he has the more likely it is that he will be able to make a better decision about lending to a particular individual.
IF the income doesn’t appear to be sufficient the lender will ask about savings and investments and equipment and things of this nature. The reason for getting this information is because the lender wants to know if the borrower will have anything to fall back on if times and tough and his regular income decreases. If there are other assets and income then this will help to reduce the risk that a potential borrower presents.
The lender may look at the borrower’s home and see how much it is worth, as well as the balance owed and the purchase price. If there is equity in the home this helps to alleviate some of the risk for a borrower. In situations where there is no home then the risk factor increases and decreases the chances that a borrower will receive the loan.
A lender may be called upon to evaluate the credit worthiness of a business. In this case they will need financial statements and cash flow statements because these will help to access the risk that a business owner or a corporation brings to the table. Some of the key factors that will be looked at are the assets and liabilities as well as the various ratios.
One of the more common ratios that lenders look at is the current ratio which basically is a comparison of the current assets to the current liabilities of a business owner or corporation. Lenders are able to take a look at this particular ratio and for the most part access the financial condition of a business.
Lenders want to see that a business owner has been in business for at least five years. At the five year mark the risk that a business has is significantly reduced because the vast majority of businesses fail within their first five years of operation.
Lenders know that if a business is able to withstand the initial trials and tribulations that are presented within those genesis years, then the business will more than likely start to receive a substantial amount of cash flow which reduces risk.
If you have a well thought out business plan then a lender will more likely want to make you a loan because they know you have put a lot of hard work, dedication, preparation and thought into making your business a success. A business plan always helps you to reduce your risk because you have a plan or a road map that for the most part guides you on to success.
To offset risk a lot of lenders will simply price their product accordingly. If the lender decides to take on a riskier customer they will extend that customer a higher interest rate. We see this many times with secured credit cards. You also see this type of lending activity with finance companies, which can offer interest rates as high as 30% for certain loans.