Let’s assume you’ve done everything a responsible borrower needs to do before applying for a loan. Meaning you’ve analyzed and evaluated your needs and financial situation, along with researching the type and costs associated with the loan. Ideally, you’ve even used a loan payoff calculator. The next step is completing a loan application with a willing lender.
Lenders look at certain criteria before issuing loans and some of this information can be easily assessed by examining an individual’s loan application – but there’s more to be considered.
The Loan Underwriting Process
From the lender’s point of view, to ensure that every loan is approved according to the guidelines designed to minimize loan defaults, a process called “loan underwriting” is initiated. Loan underwriting evaluates a borrower’s ability to repay on time and in full.
Three critical points – known as the “three C’s” of borrowing – are used by lenders to make loan decisions: credit, capacity, and collateral. The following explanations for each of the three C’s will help you understand the rationale that lenders use for approving, or not approving a loan application.
The First C – Credit
To begin, lenders will check your credit report and credit score. The three major credit-reporting agencies are Experian, Equifax, and TransUnion. These agencies, or credit bureaus as they are often referred to, provide a complete history of your credit worthiness by tracking and reporting on your loan activities, payment habits, number of credit cards, and other financial behaviors. If you have a clean slate, haven’t filed for bankruptcy, and repaid all your debts on time and in full, you’ll generally have a higher credit score than someone who didn’t. A consumer’s credit score is a three-digit number that typically ranges between 300 and 850.
The higher the score, the higher your personal credit rating – and the better chance you have of getting your loan application approved. Another advantage of having a higher credit score is that the lender may offer you a more favorable interest rate.
A Little More about Credit Scores
Credit scores are based on proprietary algorithms that offer lenders a means to determine how responsible you are at paying your debts. The three-digit credit score provides lenders with a great deal of information about the likelihood of being paid if the loan is approved and the money disbursed.
One common and popular three-digit credit score was developed by the Fair Isaac Corporation – also known as a FICO score. While the three-digit score ranges from a low of 300 to a high of 850, another credit score, VantageScore®, was formulated by a joint agreement between the three credit reporting agencies with a low score of 501 and a high score of 990.
The Second C—Capacity
When lenders try to evaluate your capacity to repay your debts, including the loan you’re currently applying for, they look at a variety of things. Your current sources of income; the length of time spent with your current employer; the likelihood that your job is not subject to market pressure or outsourcing, and that the industry you’re working in is sustainable over the long term.
Part of the capacity equation is your debt-to-income ratio. This tells the lender whether you are earning enough money to cover all of your expenses. If this ratio is too high, meaning that your income does not support your debt payments, there is a strong possibility that your loan will be rejected. This is where you may have to demonstrate that you can lower your discretionary expenses.
The Third C—Collateral
We previously discussed why lenders prefer having additional security in the form of collateral. Remember, that was part of the lender’s Plan B. If a borrower defaults on a loan, the collateral can be used to pay the lending institution so that any potential loss is minimized.
However, collateral is not always easy to value and/or evaluate. Take for example, a home. There are many variables that can affect a home’s market value – variables such as economic conditions, geography, and the condition of the home. All things considered, the lender can presumably sell the property in the event of a default on a mortgage or home equity line of credit. Similar action can be taken with an automobile loan.
Other forms of collateral are more difficult to evaluate because either the lending institution lacks expertise in a certain discipline, such as art or antiques, or in valuing securities which may fluctuate dramatically due to unforeseen events. Even with all the complexities involved in determining a collateral’s value, lenders still consider the risk of a loan without collateral to be higher – and it can frequently be the deciding factor in denying and/or granting a loan. So, the interest rate applied to a loan will generally be commensurate to the added risk.
For more information on loans contact one of our Consultants at 1-800-495-4069.