We live in a world where loans can help us afford things we need without paying for them up front. People get mortgages to purchase their first home, car loans, personal loans, and credit cards. But what do lenders actually look at when you get a loan? What determines if you’re approved or denied?
What does it take to get a loan?
Lenders will gather a wide range of information to determine whether you would be a good person to lend money to. They also need to decide if you can make the payments. One thing that a lender will look at is your credit report. This will show them your credit history and credit score. They will also verify your employment history and current income. While every lender has different criteria for loan approvals, most will calculate two ratios from the information they get: Debt-to-income ratio and unsecured ratio.
The debt-to-income ratio provides a type of financial snapshot for the lender. It helps them determine three things.
- How much debt you currently have
- How much money you make
- How well you can pay your bills without struggling
The ratio is calculated by taking all the monthly debt payments you have and dividing that number by your monthly gross income. Gross income is the amount you make before any taxes or deductions.
If the monthly payments for your mortgage, car, credit cards, and other debts equal $1,500 and your monthly gross income is $5,000, you would have a debt-to-income ratio of 30%.
$1,500 (monthly bills) ÷ $5,000 (monthly gross income) = 0.3 or 30% (debt-to-income ratio)
Typically, you want to have a low debt-to-income ratio to get a loan. If your debt-to-income ratio is around 36% or lower, you’re in a good position. Some lenders will let the ratio go as high as 40% before denying a loan.
How do you lower your debt-to-income ratio?
Paying off some of your debts can help to lower your debt-to-income ratio. It will also improve your credit history. There are a few ways to knock down your debt. The Snowball Method is one. If that’s overwhelming for you, just focus on one loan or credit card and make extra payments. If you get a bonus at work, put it on the loan you’re trying to pay off. If you win $50 on a lotto ticket, pay down your credit card. Small amounts add up, so don’t get discouraged.
You can also increase your monthly income to lower your debt-to-income ratio. If you get a raise at work, that will help lower the ratio. Getting a part-time job will also help in two ways. It will raise your income level and you could use the extra money to pay down your debts.
Unsecured Debt Ratio
There are two types of debt that a person can have: secured debt and unsecured debt.
Secured debt is typically a debt that is backed with some type of collateral that the lender can take if you fail to repay the loan. Types of secured debt would include a home loan or car loan. This means a lender can take your car or home if you stop paying them. They would sell it to get back some of the money you didn’t pay them.
Unsecured debt is any debt where there is no collateral. These include student loans, credit cards, and personal loans. A lender will figure out your unsecured debt ratio by calculating all your unsecured debts and dividing that figure by your annual income. Then, they multiply it by 100 to get a percentage.
If you have $5,000 in unsecured debt and you make an annual income of $45,000, you have an unsecured debt ratio of 11%.
- $5,000 (unsecured debt) ÷ $45,000 (annual income) = 0.11 or 11% (unsecured debt ratio)
Just like your debt-to-income ratio, you also want your unsecured ratio to be as low as possible. This increases your chances of getting a loan. Most lenders want to see a ratio that is 25% or lower.
How do you keep your unsecured debt in check?
Don’t use credit cards. These are the biggest culprits when people get over their heads in debt. To avoid racking up unsecured credit card debt, don’t use them unless you can pay them in full every month. This includes store credit cards that lure you in with extra points and exclusive discounts. If you don’t have the money for something you need, a personal loan is a better choice than a credit card. Personal loans have clear end dates, set payments, and typically much lower rates.
Increasing Your Chances of Loan Approval
Understand what your debt-to-income and unsecured debt ratios are before applying for a loan. If either is too high, seek out ways to lessen the amount of debt you carry. Start with the unsecured debt. Lowering those ratios can have a large impact on helping you get a loan.
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Each individual’s financial situation is unique and readers are encouraged to contact the Credit Union when seeking financial advice on the products and services discussed. This article is for educational purposes only; the authors assume no legal responsibility for the completeness or accuracy of the contents.