What is the credit cycle? What do lenders look at if you want to extend credit?
Much like the profit cycle depends on the economic cycle, the credit cycle is highly contingent on the economy. According to Howard Marks, the credit cycle swings wildly in response to economic changes, causing credit to fluctuate from easily available to heavily restricted.
Discover more about the credit cycle’s patterns.
The Credit Cycle
What is the credit cycle and how does it impact you? Marks explains that in times of economic prosperity, credit lenders often mistakenly believe that loans carry little risk, leading them to offer credit liberally to applicants. For example, start-up companies have little trouble securing loans when the economy is booming since lenders are overconfident that these companies can repay the loans. Consequently, creditors provide imprudent loans to unqualified applicants that carry a high risk of default.
As Marks relates, when borrowers eventually default on these unwise loans, it causes the capital market to overcorrect and become too restrictive. In other words, creditors become reluctant to issue further loans—even to qualified borrowers—causing the previously open stream of credit to dry up. The reduced availability of loans then feeds back into the economic cycle by slowing economic growth.
| Key Factors That Lenders Consider While it’s true that credit lenders might become too generous or too restrictive depending on the location in the cycle, experts note that lenders typically look at the same factors when determining whether to extend credit, regardless of the cycle. These factors include: Creditworthiness: Lenders are more likely to extend credit to those likely to pay it back. For small businesses, lenders typically consider owners’ personal credit scores to determine creditworthiness. Credit capacity: Lenders assess the financial status of a company (such as its cash flow and payment history) to determine whether it’ll likely earn enough money to pay back their loans. Collateral: Lenders are more generous when borrowers put up collateral, which refers to assets that the lender can sell if the loan isn’t repaid. For example, car loans require the car to serve as collateral. Company placement: Lenders also consider whether the company is positioned within its industry for future success. For instance, companies in burgeoning industries usually find it easier to borrow than companies in stagnating industries. Thus, one reason lenders might be too generous in times of economic growth is that these conditions are more easily satisfied. For instance, companies have an easier time establishing collateral and strengthening their creditworthiness when the economy is thriving, while they might struggle to do so amidst economic hardship. |
