Getting Approved for Loans

Capacity to pay back loans is a central component of the loans process. With getting approved for credit with credit cards, one’s capacity to repay the amount of credit extended is initially considered, but if one has a strong payment history and maintains their credit rating, often times these credit lines will be extended with little regard to capacity.

This is never the case with loans or non-credit card revolving credit lines. Even subprime lenders pay a lot of attention to capacity, even though their risk tolerance does tend to be higher and therefore they will often allow for higher debt ratios than banks. The reason is that their risk appetite is higher, but this extra risk tolerance is still fairly limited, especially where capacity is concerned.

If one does not have the reasonable means to repay a loan, the lender is just setting themselves up for failure. So, lenders use a calculation to determine one’s debt ratio, including the loan payment, to look to ensure that the borrower does have the capacity to repay the loan.

While people’s allotments of their income does differ, for instance some people may live more frugally than others, debt ratio calculations are set to a standard of reasonableness and assume that one is managing one’s affairs properly, an assumption that is derived in large part from one’s credit history.

If someone does not have a history of late payments, they have at least shown the ability to not overextend themselves by way of their non-debt repayment spending, a certain level of responsibility toward their debts, and this is assumed to be likely to continue.

Even so, lenders still want to ensure that one’s debt obligations are not too great to be managed, and debt ratios do give the benefit of the doubt to the borrower to a large degree. Typically, banks don’t want to see people’s debt payments plus housing costs exceed 40% of their gross income, and subprime lenders will go a little higher than this, but not too much higher, as this is close to the point where default rates go up a lot.

Debt payments and housing costs are costs that are fixed and are necessary, as opposed to discretionary spending, which can be adjusted since it is discretionary. If someone is eating out at restaurants every night for instance, and they get in a little financial trouble, they can cut down on their spending on food and even eat on the cheap like students do if needed, to ensure that their debts get paid.

One’s Credit History

This is one of the reasons why one’s credit history is so important in the loan approval process, to look at what has happened in the past over the last 6 or 7 years, depending on the credit reporting agency and the jurisdiction. In order to qualify for a good rate, one must have a clean history, among other things.

If there are any defaults on one’s credit history, this will usually preclude someone from getting an unsecured loan from a prime lender such as a bank, as those who have had issues over the lookback period of the credit report are more likely to default, at a rate that these lenders are not comfortable with.

Late payments of any sort can be problematic as well and keep people from borrowing from prime lenders, although if it has been a number of years since the late payments occurred, it still can be possible.

Credit scores are based upon statistics, which tell us the likelihood of someone defaulting, and this is what credit scores represent. The higher your score, the less likely you are to default, and vice versa.

Unsecured credit is often priced based upon the category of one’s credit score, with the best category getting the best rates, and other lesser but still very good or good scores getting higher rates. There will also be a threshold where one’s score does not meet the minimum requirement for approval.

Another big factor in determining one’s credit score risk is the percentage of available credit used. This has to do with revolving credit lines, and is separate from capacity.

The higher the percentage of available credit used, the more negative impact this has upon one’s score. The easiest way to understand this is that people who are maxed out are the most likely to default, and those with the lowest use, no use actually, are the least likely. This all has to do with the utilization of credit, and using available credit more represents more risk.

The Concerns of Lenders

A lot of people think that you help your credit score by using credit a lot and paying it back on time, but having credit products open but using them less or not at all shows even more responsibility and therefore is seen as more desirable and less risky.

One of the concerns that lenders have is that people will continue to get new credit products and extend themselves further after the loan is granted, and this is one of the reasons why showing restraint in using credit is highly valued, and why this is reflected in one’s credit score as a measure of the riskiness of lending to someone.

Banks work on fairly tight margins, especially compared to other industries, and if they are only getting three points over the inflation rate for instance, that’s not a lot really. There will always be a certain default rate, but in order to make a profit from lending at these rates, this has to be kept fairly low.

This is the reason why loans are priced according to risk, and why one’s credit history is so important in getting a loan in the first place and getting a good rate if one needs a loan.

Other lenders may have higher risk tolerances based upon their rates, which are higher or even much higher than banks charge, but need to be due to the higher percentage of their borrowers not paying back their loans in full.

This is all lenders care about, your repaying your loan as agreed, and they do use statistics to evaluate this, so you need to ensure that your situation fits their profile.

It is not enough of course to not have a negative history, as one also needs a sufficient positive history to have proven themselves to be worthy of the loan they seek. In terms of one’s credit score, just having a single credit product is sufficient, and having more may actually impact one’s score negatively.

This actually makes sense when you consider that people who default tend to have more credit facilities open then those who do not. Even if you use these credit products responsibly, more is not better here and one should limit the number of credit products to actual need. Many people have credit products they don’t need though and don’t realize that this can have some effect at least, although if the products have been all open for several years this tends to offset this.

Lenders sometimes will judge one’s credit history by the thickness or thinness of one’s credit file, meaning that one or two credit products may be seen as too thin, whereas more, a thicker file but not too thick, is seen as preferable.

This is the case even though thicker files can bring down your score a little, although usually not too much to disqualify you from being approved for any loan provided the products have been all open for a while. Newly opened credit products together are a bit of a red flag though and suggest a need for credit, much like too many credit inquiries together do.

Both of these factors do put your score down, so they should be avoided if possible. Credit scores do not penalize one shopping around for credit, applying at several places for a loan for instance in a short timeframe like within 14 days, but other than that, credit bureau inquiries should be kept to a minimum.

Even though your credit score may be very good or even excellent, some types of loans, especially mortgages, require a thicker credit file as banks tend to be more leery of lending that much money to someone who has only proven themselves in a limited way, with a single credit card for instance.

Getting Your Approval

Loan approvals these days can often be delivered in a matter of seconds, providing that your application is deemed to be sufficient by the computer program that is set up to adjudicate your loan application.

This system will deliver either a yes, a no, or a maybe. Your application may be close enough or may involve variables that the computer has not taken into account, such as using the loan to pay out other loans, where the system may not be able to account for that.

In these cases, your application may be sent to a human adjudicator for review, which of course takes longer but the adjudicator will have more flexibility in approving your application. When the computer does not approve you, this is the only way to get approved.

Loan applications are usually approved pending income verification, and most of the time you will have to provide income documents to substantiate the amount of income you reported on your application. If the amount verified is less than what is reported, the application may have to be requalified. Depending on how far off it is, you may or may not be approved based upon this amount.

Loans, whether installment loans where a lump sum is provided for a specific purpose, or a revolving loan, which offers the borrower the ability to borrow up to a certain amount on demand, can be very helpful in managing one’s everyday personal financial affairs and to also enjoy life to the fullest.

Having a good understanding of how lenders see you and how they evaluate your loan applications will place you in a better position to ensure that you are doing your best to give them what they are looking for and be more likely to be approved or approved for the rate you are seeking.