After working nearly a decade in personal finance and consumer based lending; I have learned one crucial fact that I employ daily in my own private life:
Getting “approved” for a loan will never mean that you can actually afford the loan.
Here’s why you need to live by this rule.
Getting “approved” for a loan will never mean that you can actually afford the loan.
This is it. This is literally the secret to financial success. Just because you can do it, doesn’t mean you should. If you’ve been following me for the last year, you’ve officially learned the secret formula. This is the biggest and most life-changing “insider info” I can ever give you about finance. Thanks guys. Signing off.
I’m actually not joking. If you want to know how a few ways that lenders don’t put your interests ahead of their own… keep reading. I’m about to take my consumer finance hat off, put my consumer advocate hat on, and break this whole philosophy down.
Buy now. Pay later.
There are many mantras that I use in my life. One of my favorite “go to” phrases that can actually be applied to nearly every area of life from politics, relationships, and advertisements, to negotiations and careers would be this:
“Listen to what they are saying, but remember what they stand to benefit from if you do it.”
When we are talking about lending…more specially, your money… you need to remember what you stand to gain, and what you stand to lose. It doesn’t matter how much money you make, or how good/bad your credit is. The game is the same.
Conventional, consumerism says that you stand to finally get what you heart desires and crave to achieve happiness:
- The keys to your dream house.
- New car smell.
- 4K high definition.
If we don’t have the money, we can get a loan for it. Payments are flexible, and so are the terms. Many lenders even let you skip making payments for the first 90 days, or give you interest- free financing for many months. But that concept of “buy now, pay later” is sold to us by the exact people who want to sell those various products and items to us.
If we buy, they gain something. But, what do we stand to lose?
The lending industry can be summed up in one word: Risk.
The lender will do everything in their power to approve you for as many loans as you want, so long as they’re not placed in a risky situation (Not you…THEM). Let’s be truthful…Many people feel as if getting approved/denied for a loan is this mysterious process that you can never fully understand like the powers of a Ouija board, or filing your taxes, but your approvability weighs heavily on three simple factors:
- Collateral – Whatever you’re getting the loan for. What is it worth? Car, Truck, SUV, Boat, RV, ATV, House. Your Signature.
- Capacity – You income (and its length/stability), amount of debts you currently have, and how the proposed loan will affect your ability to pay.
- Character – How you perform, historically. Do you stay gainfully employed? Do you let bills become past-due? Are you requesting this new loan with good intentions?
It’s really as simple as that. As long as your application and ratios are within the lender’s guidelines based on their risk tolerances, you will get approved.
However, let’s speak on arguably one of the most intimate portions of your loan application: Debt to Income.
40% Means You’ll Never Be In The 1%.
Your Debt To Income Ratio (DTI) or Income to Debt Ratio (IDR) may sound confusing, or as if they are two different things, but both DTI & IDR is the same thing and is actually exactly what it sounds like: How much income you produce, versus how much debt you have.
As a general rule, but not a fact, most lenders want your DTI to stay around 40% or below. They are referring to payments, not balances. So, what they are looking for is to ensure that forty percent of your pre-tax wages (or less) are being paid out to lenders. Not bills, lenders. Mortgage companies, auto loans, credit cards, student loans, etc. If your DTI gets too far above 40%, your chances of getting denied escalate rapidly. If you DTI is far below 40%, your chances of getting approved escalate rapidly.
Here’s an example: If you earn $2,000 per month, your lender doesn’t want you to pay more than $800 per month towards student loan payments, car payments, mortgage/rent payments, credit card minimum monthly payments, etc.
The math… $800 = $2,000 X 40%.
Don’t get it twisted, 40% is not a regulated number. Debt to income ratio exceptions are made every single day where a lender says “this loan is going to move their DTIts above 40%, but… here’s why we can make a one-time exception and approve this loan.”
Debts to income exceptions aren’t made for malicious intent, and there is a very high chance that you will never know that an exception has been made for you. Why are they necessary? Good question. There are many times when the lender realizes that the new loan slightly above 40% DTI may enable you to keep paying other loans, or to stay above water financially.
For example: a car repair would keep your car running/usable, keep you employed, and motivate you to keep paying your car payment on time.
Another scenario where a DTI exception may be made would be that you work in an industry where your paycheck fluctuates, but you’ve got confirmed prospects that would boost your future income.
Or, more often, the lender sees that you don’t miss payments (with them and/or other lenders), so going a little bit about 40% DTI isn’t a big deal…because you’re good for it.
However, I take personal offense with this “Debt to Income” concept when we are talking about my own money.
First, your DTI is figured based off your pre-tax wages, even though you pay ALL of your bills with your post-tax paycheck…which might be hundreds of dollars less once Uncle Sam takes his cut. This means that your lender probably said “oh, Adrian can afford this new loan” and approved me for it based off a paycheck that is actually hundreds of dollars above my actual direct deposit.
Second, your lender does not take into account the various things you may personally want to do financially. Perhaps you’re interested in saving for a vacation to the beach, put your kids through college without student loans, fix your car, covering these high winter energy bills at home, oh…and eating. I am sure that we all want groceries, shelter, and clothing.
Your lender wants you to have these things, also, so long as it doesn’t affect their 40% DTI ratio. To be fair, the lender WILL “consider” that you need money beyond what you pay out to lenders in order to survive, but trust me… they’re not spending the bulk of their time analyzing how much of a priority saving up for a new refrigerator is to you.
Today’s Profits > Tomorrow’s Potential
Another thing your lender isn’t prioritizing with the same passion as you would be your future lending needs. Perhaps you are replacing your car, but your significant other’s ride will need to be replaced in three years. The lender will loosely consider your future financial state, but they are NOT sitting down at their wooden conference tables with our loan application and paystubs saying “you know, Adrian will have this new car financed for 5 years, but we don’t have faith that his husband’s car will stay alive until Adrian’s car is paid off five years from now. They may want a second auto loan soon. We need to make sure they can afford both easily”. Girl, bye.
Being a defender of your future goals and needs is your responsibility, not theirs.
If you stretch yourself to buy a great new car for yourself, you may find that your debt-to-income ratio is now too steep to afford your significant other’s new car payment alongside yours in three years, and you’ll get denied for the loan. This doesn’t change the need for the second car, but that’s your problem…not theirs. This truth may exist for any new loan, too. If you rely on credit to help you deal with unexpected situations…getting denied due to your DTI being too high can make a bad situation become dire.
My final gripes about “debt to income” are two words: Interest Accrued. For entertainment and illustration sake, I am going to oversimplify how interest-due on loans works, but my point remains the same.
Let’s say you borrowed $5,000 cash at 25% interest. In your mind, you borrowed $5,000.
In reality… assuming you make your payment on time every month and don’t pay it off early, you actually borrowed at least $6,250. Five thousand for what you bought, and another one thousand dollars for the privilege of buying it before you saved up your own money. It’s the cost of borrowing money, and that interest rate depends heavily on how risky they feel that you are to loan to.
However, as far as you are concerned, that extra one thousand dollars you will owe isn’t factored into your loan affordability by the lender. In fact, it isn’t factored in at all when it comes to your approval/denial. For many Americans, $1,000+ is more money than they make on their paycheck. If your boss conveniently reduced your paycheck by $1,250… you’d be hurting. I would too. Yet, when we get into the mentality that “Approved” means “affordable”, we are consenting to our lender reduce our paycheck by $1,250.
Everything has a price.
Ultimately, you have to be the steward of your own finances, goals, and dreams.
Loans are excellent financial tools that let you leverage things in your life to help you accomplish goals or desires, but it’s your own responsibility to use loans as a financial tool and not as a financial enabler. Using loans to bridge a very temporary gap, reap cash-back rewards for purchases you already planned to make, or borrowing for a major purchase at a low interest rate so your cash can stay invested at higher rates is a great use of lending.
Taking out a loan to buy something you don’t need to impress yourself, or others, is a great use of lending…for the lender. Not you.
You always need to remember what the other party stands to benefit from your actions.
If you want a loan bad enough, somewhere…somebody will approve you. However, just because you can get approved doesn’t mean you can afford it. It’s your own responsibility to decide what’s more important to you… a shiny new item to show off, or not being forced into staying a slave to your salary for years to pay it off.
Regardless if how many approved loan decisions they give you, the final decision is always yours.
Remember that, and you’ll always stay one step ahead.