Screening for Credit Risk
Landlords utilize a variety of risk assessment tools and predictive models to help identify potential liabilities and possible threats to business operations. One of the biggest concerns for a landlord is whether a potential tenant could be relied on to pay full and timely rent. Accordingly, to reduce problems associated with rent defaults, a landlord screens an applicant for credit risk. The credit report is the most widely used screening assessment tool to evaluate an applicant’s ability and willingness to pay rent obligations as agreed.
By diligent screening a landlord seeks to determine whether the applicant has sufficient, verifiable sources of income to meet rent and other living expenses and has demonstrated satisfactory credit management in his willingness to meet debt obligations.
Financial ability and satisfactory credit management are at the center of applicant qualification and approval for tenancy. Consumer credit reports are valuable informational resources that provide critical data for financial analysis and evaluation. The information in the credit report should be considered in context of the source and reporting period of contributing creditors, not as an absolute indication of credit worthiness.
Financial Ability
An applicant’s financial situation is often the critical decisioning factor in tenant selection. A landlord will evaluate the applicant’s financial situation based on data from screenings such as a credit report, credit score, income verification, income to rent ratio, debt obligations, public reports and references.
Screening for ability to pay and willingness to pay should be backed by the applicant’s management of his financial resources to meet credit responsibilities. There should be adequate history of the applicant’s commitment to meet his financial duties and obligations.
Income
The ability to make rent is largely dependent upon income sufficient to pay rent, living expenses, and debt obligations. The income to rent ratio of 3:1 is a generally accepted industry standard for income qualification. For some landlords a steady income such as wages from a verified employer may be an important decisioning factor, possibly more so than other factors. While past history of meeting debt obligations is important, the future ability to pay debt is critical.
Financial ability to pay rent can come from various sources of income. Wage earnings are the most common source of income. Other sources of income include self-employment, stocks and bonds, trust funds, mutual funds, spousal or child support, government assistance, and income from rental properties. A landlord must conduct his due diligence for state and local laws regarding fair housing protections against source of income discrimination. A landlord whose income requirement for tenancy is proof of income from W-2 wage earnings is in violation of fair housing laws in some states and municipalities. In many states a landlord is required to disclose his rental criteria for tenancy and must provide applicants with the written standards for supporting documents for income/funds verifications.
Verification of non-earned income, such as interest, dividends, annuities, Social Security or disability benefits, IRA/401(k) pension distributions, other retirement plan distributions, court-ordered agreements for spousal support, child support or as awarded by lawsuits, and other investment cash flow and entitlement items, may be verified through copies of official statements made available to the landlord by the applicant.
Credit Report
Credit reports provide a broad overview of an applicant’s financial status. A consumer credit report as a primary credit screening tool allows a landlord to review the applicant’s credit history, open and closed accounts, and payment history. If the payment history shows slow pays or missed payments it may be an indication that the applicant could have difficulty in making future rent payments.
In analyzing the applicant’s credit report, many landlords focus on items that can be significant indications of credit risk. The frequency of late payments and/or a pattern of late payments on multiple accounts could be an indication of financial difficulty or an indication that the applicant does not take his credit obligations seriously enough to meet payment terms.
A landlord should note whether the credit report contains negative items or potentially negative items, such as collections, accounts past due, or debts discharged. Credit accounts sent for collection or collection accounts that have been charged off can be signs of credit risk that a landlord should not ignore.
The landlord should carefully analyze the applicant’s debt load in relationship to the applicant’s monthly income. If the amount of the applicant’s monthly payments against debt is subtracted from the applicant’s monthly income, is the amount remaining sufficient to meet the rent payment and cover reasonable living expenses?
Credit Score
Traditionally a landlord has utilized the consumer credit report as the key document for measurement of an applicant’s qualifications to rental standards. A scored credit report has been regarded as an objective, measurable, and defensible method of evaluating financial risk to the landlord’s business. The applicant’s use of credit, credit payment history, and debt exposure were set out as indicators of future credit performance.
There are a number of credit scoring models and each model may use different factors to calculate a credit score. A credit score is a general indicator of financial responsibility. It should not be used as an absolute measurement of credit risk.
A credit scoring model looks at how much is owed on all accounts, how much is owed on specific types of accounts, the number of accounts with balances and how much available credit is shown for each account. The proportion of balances to total credit limits for revolving accounts and the proportion of balances to original loan amounts on installment loan accounts will be a consideration in the credit evaluation. In brief, the more money that is owed compared to the credit limit, the lower the score will be.
Generally, a longer positive credit history on an account will have a positive effect on a credit score. Length of credit history considers the time since accounts were opened, the specific type of accounts opened, and the time elapsed since account activity.
The type of credit is also a factor in a credit score. A mix of different credit types, credit cards, retail accounts, installment accounts, revolving accounts, mortgage loans, or personal lines of credit, etc. is considered in evaluating the overall credit risk. Too few accounts or too many accounts of only one type of credit can be indications of potential risk.
Recently opened accounts are given consideration as to the number of new accounts and the type of accounts. New credit inquiries, both the number of inquiries and the time period in which they were made, may also have an effect upon the credit score. Some credit bureau models also give consideration to the re-establishment of positive credit history after past payment problems.
It is more likely that an applicant with a higher credit score will have the ability and willingness to pay as agreed, and less likely to default on his obligations. A low credit score should not automatically disqualify a potential tenant any more than a high credit score would automatically qualify the applicant.
However it should be noted that a credit score is only one part of a comprehensive credit risk assessment. A credit score serves as a general indicator of financial responsibility rather than an absolute measurement of credit risk. It can be used as a predictive model of the applicant’s ability to pay and to pay on time. It is not a guarantee that the applicant will be a good or bad tenant.
References
Landlords can contact rental references to confirm the applicant paid as agreed while a tenant at a former rental address. Credit references can be contacted for those creditors who have extended credit or otherwise established a financial relationship with the applicant but who do not report payments or payment history to the major credit reporting bureaus.
Rental Standards
A landlord must set his rental standards to meet his business requirements. Formalized written rental screening and selection standards set out minimum qualification requirements for tenancy. Typically these requirements specify a minimum gross monthly income, a satisfactory income-to-rent ratio, positive references from previous landlords, satisfactory credit report and debt payment history, no history of illegal drugs or illegal activities, no derogatory public records, and satisfactory background checks.
Setting high rental standards could help minimize risk of lease defaults. However standards that are too high can reduce the applicant pool and extend vacancy periods. Standards should be objective, measurable, and relevant to the applicant’s performance as a tenant. The rental qualification criteria should point to the important issues – the ability to pay timely rent, acceptable credit history, and satisfactory previous landlord references.
Each tenant selection is an informed business decision based on rental standards universal to the landlord’s business. Each and every potential tenant is evaluated using the same standards, in the same established process utilizing the same risk assessment tools.
Standards set by a landlord should take into consideration regulatory requirements, local market supply and demand, business necessity, property location and condition, and the landlord’s ability to carry business risk and his willingness to manage that risk.