When you apply for a loan, what does the loan officer look at
before approving or rejecting your application?
Here’s the inside scoop on what matters to your lender.
Whenever you apply for a loan, your financial institution will evaluate your loan application, decide if you’re going to be a good or bad risk, and make a decision. Lenders are in the business of loaning money.
If they make too many loans that go unpaid, it can jeopardize the entire company.
This post will focus on prime lending. Payday lending, title loans, and quick cash loans will be covered in future posts.
Each time you apply for a loan, your credit and personal profile are scrutinized based on many aspects, but it all boils down to three things…
Collateral | Capacity | Character
- Collateral: What are you trying to finance, and why?
- Capacity: Can you comfortably afford your payments now, and in the future?
- Character: How good are you for paying your past debts?
Let’s explore these areas a bit.
No matter what they’re marketed as, or what they’re designed to be used for, ultimately there are only TWO types of loans.
- Secured: Auto. Home. Motorcycle. Boat. Home Equity
- Unsecured: Credit Cards. Student Loans. Lines of Credit. Signature/Personal Loans
Secured loans are the least risky for a lender because they know exactly when/where you are using the money, you’ve got something to lose if you stop paying, and they’ve got something to sell and recoup their money with. They also offer lower interest rates and more favorable repayment terms.
Unsecured loans offer greater flexibility with when/where you can use it, but they are reserved for people with stronger credit profiles who have history showing that they can be trusted to pay back a loan as agreed, since their signature is the only “pledge” the lender has. Because of this repayment risk, unsecured loans have higher interest rates.
In lender world, secured loans are generally the preferred loan.
However…just because you’re pledging something for the loan doesn’t mean you’re instantly approved. They’re going to evaluate one aspect more heavily in secured loans: Loan to Value.
The Loan to Value (LTV) is literally that… a ratio that measures how much money they are loaning you versus how much value the item has. You don’t want to pay for more than a car is worth, and the lender doesn’t want to loan you more than its worth, either.
Although 100% is available for strong borrowers, your lender will be more likely to approve your loan if you put some “skin in the game” by making a down payment.
A Down Payment does two things. It shows that you’re willing to put up your own cash to offset their risk, and it lowers the LTV. Why does this matter? Studies show that if you put down your own cash, you’ll be less likely to default on your loan. Likewise, if the lender has a good LTV, they won’t have to worry about your car (or whatever) selling for less than the loan balance if they have to repossess it.
GAP: Guaranteed Asset Protection policies are your friend if you think your car/motorcycle/etc will lose value before the loan is paid off.
Here’s a common example of GAP: You buy a car and get a loan for $10,000. After you make a few payments, somebody hits your car and totals it. You still owe $9,000, but your insurance company says they will only pay $8,000. You’re short 1k from the payoff…and your lender is going to expect you to pay off the loan. That’s where GAP comes to the rescue.
GAP is a policy that you can purchase from your lender (when you first get the loan) that will typically pay up to 150% of the value in the event of a covered loss and insurance shortfall. It’s a small price to pay for peace of mind and to avoid owing thousands of dollars on a vehicle that you can no longer use.
GAP is only available for secured loans.
Ultimately, if your loan to value is favorable…you’re starting off your application in good shape. Moving on.
This is mainly two simple, but important things…
Job/Industry Time: How long have you been on your job? Is it a stable job with stable hours and pay? Do you work in a similar field? All of these things matter. If you have long gaps of unemployment, work a temporary job, suffer hour cuts, or job-hop…it will make you appear to be a riskier borrower because your paychecks appear to be inconsistent. Maybe you can afford the loan today, but can you afford it in six months?
Debt To Income: All things considered… how much of your monthly income is dedicated towards debts? Most lenders don’t want more than 40% of your total income tied up to debt. Why? Studies show that people who have more than 40% of their total monthly income obligated to monthly payments will be more likely to default on their loans or file for bankruptcy. Moral of this story, the less you owe per month, the better.
The lender will take your credit score into consideration, but they’re going to be checking out your history to answer a few important questions. How have you paid past loans? How often are you out getting new loans? Are you maxing out your credit cards? Have you had any charged-off accounts, collections or bankruptcy?
These all matter…and they are pretty easy to understand.
Past Obligations: Do you pay other people on time? If somebody borrows money from you and doesn’t pay you back…can you really trust them to borrow more?
Debt Acceleration: Are you constantly getting new loans? For the same reason that too many credit inquiries will hurt your score, this may be an indication that your spending habits are outpacing your income.
Maxed out: If your credit cards are maxed out, it shows that you are depending on borrowed money to survive. Sure, every now and then life happens and you may use a majority of your credit limit…but if this is evident on many credit cards and stays over many months, it will suggest that you may be near a financial disaster.
Charge-offs / Collections: This is proof that you had a loan or obligation in the past that you stopped paying, and the lender had to write that debt off as a loss. Plain and simple. Although leniency is given to medical collections, it looks bad if you have a ton of loans that you’ve simply given up paying. Charge offs and collections will stay on your credit report for 7 years, but paying them to a $0 balance shows a bit of good faith, so aim for that if this is your situation.
Bankruptcy: You had debt. Something happened. You went to court to legally say you can’t afford these debts. Every lender that was included took a loss. Do not pass go, do not collect $200. Although with hard work you can rebuild after a bankruptcy… it will stay on your credit report for 7-14 years.
If your character suggest that you’ve treated other lenders well, you shouldn’t have any problems. If it suggest that you’ve struggled just to stay away from the repo man…you’re going to need to do some work before you can get approvals and/or the best rates/terms on loans.
Loaning money isn’t black and white, and no two people are the same. Your lender will take your collateral, capacity, and character into account, weigh everything out, and come to a decision based on what that institution deems as a good risk. You may be approved, offered the loan with different terms/stipulations, or simply denied.
Every lender is different, but they all look for these same things before determining an approval or denial.
Knowing what they are looking for and preparing yourself can be the difference between getting approved and denied.
Helpful links: Want to know more about what affects your credit score & report? Click HERE. What are too many inquiries on your credit? THIS link is for you. How the heck do you build (or rebuild) credit? Your answer is HERE. Suffered a repo? Ready to rebuild? Check out our ARTICLE on that.