The Basics of Lending

As is the case with banks and financial institutions, there are many criteria that ACCFutures examines when an individual or business makes application for a business loan or equity investment.

Don’t be discouraged; the intent is not to discuss them all here, but rather, to provide a sense of the more important ones that we look at early in the process – ideally before going through the effort of constructing elaborate business plans and financial projections.

Prospective borrowers should know also that in the spirit of efficiency, it is not uncommon for lenders to follow an intuitive hierarchy in assessing eligibility, where if one criteria in the hierarchy is unsatisfactorily met or unfulfilled, the next, lesser important one might typically not be pursued and the application declined.

In working with individuals, start-ups, and established businesses seeking to grow, ACCFutureswill typically and in the order presented be influenced by:

Personal Credit

The personal credit, such as the Beacon FICO scores, is generally held to be the most important criteria in consumer credit and can likewise have significant importance in business lending. While the Beacon score at Equifax is highly recognized in Canada, reliance can also be placed on the Experian/Fair Isaac Score at Experian and the Empirica score at TransUnion; all of which are recognized credit reporting agencies.

Simply stated, personal credit scores can be interpreted as the payment history or habit of an individual with their past and current creditors. The report as generated by a credit reporting agency represents to a prospective lender a trajectory of the applicant’s behaviour and serves to enhance the predictability of the applicant’s ability to satisfy payment obligations on an anticipated loan – taking into consideration also the projection of all reported obligations. Quite naturally, applicants with bad credit including events such as tardy payments, collections, severe missed payments, and bankruptcy will attract increased scrutiny and possibility of decline.

Stability

Stability can be assessed in a number of ways and generally intends to provide some insight into the individual’s establishment in society. While stability can be demonstrated and considered in a number of contexts, the most popular include:

• Time period at occupation or job – An important aspect of stability is the length of time in a job or vocation. The longer the time spent by an individual, the more they will be seen as professionally settled and less likely to become unemployed or under-employed. In borrowing circumstances, employment and patterns of gainful self-employment or business, assure income; the main source of debt servicing. In short, the loss of a job or the inability to earn income increases vulnerability and the risks of defaulting. Regular and timely payments are deemed more certain by a lender when a person has job or occupational stability.
• Housing arrangement – The living arrangements of an applicant play an important role in assessing stability. While it may not always be the case, a homeowner for example is seen as being more predictable and as having more responsibility when compared to a tenant and is seen to be at less risk of moving away. Being a homeowner is seen as positive by a lender in assessing stability.
• Time period at present address – Sometimes overlooked by applicants, the period that an individual has resided at a current or previous address positively affects assessed stability. While exceptions can present, statistics and analytics generally hold that individuals having lived a short period of time at their current (or previous) address are more likely to move away and to abandon debt. Subject to objective judgement, and weighted as the circumstances may dictate, having lived at the same address for an extended period of time establishes stability and improves a lender’s prospect of extending credit.

Debt Ratio

The debt ratio, a commonly applied financial ratio, is simply the ratio or relationship between monthly debt payments inclusive of the new financing sought relative to monthly gross income. The limits of an acceptable debt ratio will typically be in the range of 35% to 50% depending on nature and terms of financing. Importantly, acceptability is heavily influenced by the first two criteria of personal credit and stability respectively and an excessively high debt ratio can cause a loan request to be declined irrespective of the strength of credit score or stability of the applicant.

Net Value

Net value, or net worth, is the financial equity of an individual or entity. It is represented simply as the difference between assets and liabilities (debt) and is calculated by subtracting liabilities from assets – where a weak or negative net figure will typically disqualify an application. Assets taken in consideration include such tangible property as real estate holdings, verifiable business holdings, and investments; where up to 50% to 80% of their value will be considered dependent upon risk level. In some instances, durable goods, cars, and other vehicles can be considered assets, although they are admittedly deemed less appealing given that they constantly depreciate or devaluate with time. The biggest asset for most individuals is normally residential real estate; however, it should be noted that these assets are the least liquid; where selling the house to pay debt really constitutes a source of last resort. Therefore, a decision cannot be based solely on the net value of an individual or entity without due consideration of the aforementioned criteria. That is, the value of residential real estate, should be more of an indicator of how deep pocketed an applicant is, than as an absolute guarantee of liquidity or credit worthiness. If an individual or entity has good equity in realty property, it will weight considerably and favourably in a credit application not necessarily because the property can be included as a guarantee, but rather because untapped equity always grants someone the possibility of obtaining additional indebtedness on the mortgage, which can help remedy financial obligations.

Occupation and Personal Circumstances

• Professional Status – Occupation is taken into consideration in a credit application. Professionals such as physicians, lawyers, accountants and engineers will attract favourable consideration, as too will others such as allied health professionals, teachers, licensed tradespeople, firefighters, and police. Where there is lack of predictability of work such as the case may be for self- employed and seasonal workers, or where it is difficult to gain employment after job loss, such as the case may be in manufacturing, said characterizations shall be assessed in establishing economic resilience and in determining lending risk.
• Personal Status – While it may be considered discriminatory, such conditions as age and marital status will be taken into consideration. It is defendable however in that such characterization is not motivated by personal judgement, rather by the realities of the applicant. For example, the chances of default are much higher for those under 30 years of age than those over 50 years of age. Meanwhile those under the age of 20 years have been revealed as the highest risk cohort. Likewise, married individuals will be seen as less exposed to risk than single individuals given their ability to pool resources and to jointly shoulder hardship.

Taken together, these attributes help shape the prospect of securing financing, the identification of security or collateral, and the determination of the interest rate. In the case of personal loan, line of credit or other loan where the decision is based only on the individual applicant, the conditions and the interest rate will fluctuate with the responsiveness of the candidate’s profile to the afore-described criteria. It is worth noting that in the case of credit cards, these criteria will not weigh as importantly since the interest rate is already relatively high, reducing some risk of monetary loss for institutions. The same principle may likewise be applied on a mortgage or the financing of a vehicle –where collateral can serve to lower the acceptance threshold.

In general, lending institutions are looking for consistency of payments on the debt and will consequently look at the reliability of the borrower, expected regularity of payments, applicant’s payment capacity, and lastly, the lender’s ability to recover missing payments in case of default.

ACCFutures encourages you to take these personal conditions into consideration when contemplating a business loan and to make an appointment with an ACCFutures Business Advisor if starting or growing your business is right for you.