Many people often wonder what it takes to qualify for a loan, asking, “What factors will lenders use to determine if I’m eligible?” “Will past mistakes hurt my chances?” Will I qualify for enough money?” It can be very intimidating and difficult to understand process for first-time loan seekers.
The reality, however, is that lenders use very specific criteria, known as the “5 C’s of Credit,” to determine eligibility for a loan, and none of it is hidden. While there are numerous factors that determine whether or not you both qualify to receive a loan and under what conditions, these are factors that you can control and influence, whether you have good credit or not.
This guide will help to familiarize you with the different factors that lenders use to determine your eligibility, and how they can affect your chances.
First, and foremost, lenders will analyze your credit score to help deciding whether or not to offer you a loan. Your credit score is a number, usually anywhere between 300 and 850, that determines your ‘risk,’ or how likely you’ll both honor your agreement with a lender and be able to pay them back on time. The higher your assigned number, the less risky a lender will assess you to be. Your credit score is primarily affected by factors such as:
- Your credit history – how many different lines and types of credit, such as credit cards, mortgages, car loans, college loans, etc., you have had open over a period of years, and if you have paid your minimum payments on time. The more time that you’ve had access to different lines of credit, the more it can impact your score.
- Credit limit and use – This refers to how much of your approved credit you’ve used at any given time. For example, if you have a credit card with a $10,000 limit, and you use $3,000 in one month, you’ve used 30% of your credit limit. Lenders typically do not want to see you using more than about 30% at a time, and no more than 50% at the maximum.
- Defaulting on payments – If you’ve missed a payment, had to declare bankruptcy, or ever had a car repossessed because of failing to make your minimum payments, these will all be factored into your final credit score.
The final thing to know about your credit score is how to check it. There are three major agencies, Equifax, Experian and Transunion, that composite your credit score, also called a FICO score. Each agency will offer to let you check your credit score for free, once per year.
Capacity refers to your projected ability to afford your loan payments and pay them on time. The primary factor in determining your capacity is your DTI, or Debt-to-Income ratio. Your DTI is an assessment of how much money you make versus how much you are obligated to pay.
For example, if you make $2,500 per month at your job, and your expenses, including things such as your car and house payments, total $1,500 per month, your DTI is 60%. Typically, lenders do not want to see a DTI of higher than 36%, and most mortgage lenders will not lend above 43% at the maximum. Other factors that impact your capacity are your current employment status, and your employment history.
Capital refers to the different funding sources you can use to pay off the loan, and investments up front. Typically, your regular household income from your job will serve as your primary capital, but other examples include savings accounts, matured bonds and stock market investments.
Another good example of capital that lenders often call for, and in some cases require, is a down payment on the loan, because it shows that you are committed to the loan and have the resources to pay it off over time. Lenders consider your capital because there is always the chance that you will lose your job or that other emergencies in life will come up over the life cycle of the loan, and you’ll still have to make your minimum payments.
Collateral refers to any assets that you pledge to ensure payment on the loan, in the event that you fail to make your minimum payments. Examples of collateral can include your house, your car or any investments you may have. Secured loans require some form of collateral.
It is easier to get a loan if you use collateral, but the risk to you is that if you default on your loan, you will lose whatever you have agreed to as collateral. Unsecured loans, while potentially more difficult to get, ensure that, even if you default, you won’t lose the possessions that mean the most to you. How much collateral you have, and how much you are willing to commit, can be a huge factor in determining the type of loan that’s right for you.
In its most basic aspect, conditions refers to how you (the borrower) intend to use the money you are loaned. More stable and ‘normal’ types of loans, such as car loans and mortgages, are common and lenders are more open to giving you better conditions. More unorthodox loans, for example, to take a luxury vacation that you couldn’t afford otherwise, will raise concerns that could hurt your chances of being approved for a loan. Other conditions that play a role in determining your eligibility are the interest rate, the current state of the economy, and any environmental considerations.
Lenders use these factors to determine your eligibility for a loan, and also what kind of conditions they will offer you. Better results on the factors we have discussed will demonstrate to lenders that you are trustworthy and responsible, and will improve your chances of getting a better loan.
Even if your credit score isn’t great, or you don’t have the best paying job, you don’t need to be discouraged. There are many options you can take to both improve your scores and get the money you need, and now that you have a better understanding of what lenders use to help them make a decision on your loan, you’re in a much better place to make the decision that’s right for you.