When applying for a loan from a bank or financial institution, there are several factors they will consider to determine if you qualify and how much you can borrow. Banks need to assess the risk of lending money and your ability to repay the loan. They want to feel confident you will pay back the money as agreed without defaulting.
Some of the main criteria banks evaluate include your credit score and history, income, existing debt levels and obligations, collateral, and the purpose and type of loan you need. The better your financial profile, the more likely you’ll be approved and offered better terms on a loan.
What is your credit score and history?
Your credit score is one of the top things banks look at when reviewing a loan application. Your credit score summarizes your past borrowing and repayment history into a three-digit number. Scores generally range from 300 to 850.
Higher credit scores signify to lenders that you are a lower credit risk and more financially trustworthy. If you have a long positive credit history and high credit scores, banks will view you more favorably than applicants with poor or short credit histories.
Some key factors that influence your credit score include:
– Payment history – Have you paid your past debts on time and as agreed? Late or missed payments can negatively impact your score.
– Credit utilization – This measures how much of your available credit you are using. High balances can hurt your score.
– Length of credit history – Lenders like to see you have successfully managed credit for many years.
– New credit inquiries – Too many new credit applications in a short period can lower your score.
– Credit mix – Having different types of credit (credit cards, auto loans, mortgages, etc) can help your score.
When you apply for a loan, the lender will check your credit report from the major credit bureaus. This shows your score along with the detailed information used to calculate it – your payment history, current debts, collection accounts, bankruptcies or late payments.
Banks generally look for credit scores of at least 620-650 to qualify for a loan, but requirements vary by lender. The higher your score, the better your chances.
Tips for improving your credit score
– Pay all bills on time every month
– Keep credit card balances low
– Avoid opening too many new credit accounts
– Check for and dispute any errors on your credit report
– Become an authorized user on someone else’s account
What is your debt-to-income ratio?
Your debt-to-income ratio (DTI) is another major factor banks evaluate. This measures how much debt you have relative to your income. It’s calculated by dividing your monthly debt payments by your monthly gross income.
For example:
Monthly income: $5,000
Monthly debt payments (mortgage, credit cards, student loans, car loans, etc): $2,000
Debt-to-income ratio: $2,000/$5,000 = 40%
Lower DTI ratios indicate you have more disposable income available to take on and repay new loan payments. Many banks look for a DTI of 36% or less for approval. But maximum DTI requirements depend on the lender and loan type.
Banks will tally all your current monthly debt obligations like credit cards, auto loans, student loans, child support, taxes and insurance when calculating your DTI. Your proposed new loan payment will also be counted to determine if it fits within your DTI limits.
Having a lower DTI helps your chances of loan approval and can allow you to qualify for a larger loan amount. A high DTI signals too much existing debt burden and that you may struggle to afford additional borrowing.
Tips for improving your DTI
– Pay down balances on installment loans and credit cards
– Consolidate high interest rate debt into a new lower rate loan
– Make extra mortgage principal payments to pay it down faster
– Refinance high interest loans at lower rates to reduce payments
– Increase your income with a second job or promotion
How stable and sufficient is your income?
Lenders want to see consistent income that shows you can reliably make monthly loan payments. When reviewing loan applications, banks will evaluate your income sources, stability over time, and total earnings.
Factors assessed typically include:
– Employment status: Having steady employment helps versus being self-employed or frequently changing jobs.
– Length of employment: Being at the same job longer instills confidence in your stability. Many lenders look for 2+ years.
– Type of employment: Traditional W-2 employees often viewed as lower risk than contractors or self-employed.
– Number of incomes: Multiple income sources balances risk if one source lost.
– Income history: Tax returns show earnings trends over time. Steady or increasing ideal.
– Total income amount: Higher incomes more likely to qualify, absorb payments.
– Debt-to-income ratio: Measures if enough income left over after debts paid.
Providing pay stubs, W-2s, tax returns, proof of rental income, investment dividends or other documentation helps verify your income levels to the bank.
Some lenders may average your income over time. Make sure your application shows consistent earnings over the last 2 years through current pay stubs. Any big fluctuations or gaps will need to be explained.
Tips for making your income look more stable and sufficient
– Avoid job changes before applying for a loan
– Explain any employment gaps or inconsistent income
– Use accounts like direct deposit to document steady pay
– Get employers to write letters verifying your employment and salary
– Open new credit accounts sparingly that may cause inquiries lowering score temporarily
How much cash reserves or assets do you have?
Lenders favor applicants who have ample assets, savings and cash reserves. These provide a buffer if your income was interrupted and make you less likely to default on a loan.
Many banks want to see minimum emergency savings of 3-6 months living expenses or at least a few thousand dollars. The more assets and reserves you have, the better.
Accounts banks may review include:
– Checking and savings account balances
– Retirement accounts like 401Ks
– Investment accounts and stocks
– Cash value life insurance
– Real estate equity
– Business assets
Having substantial assets and emergency funds eases the bank’s mind that you can withstand financial hits like job loss or expenses between pay checks. It demonstrates financial stability and discipline.
You will need to provide recent account statements and documentation of assets. Treasury and brokerage statements, property valuations and insurance policies are typical documents.
Tips for boosting cash reserves
– Build up emergency fund savings
– Limit unnecessary purchases and discretionary spending
– Save windfalls like tax refunds rather than spending them
– Sell unused possessions like furniture or electronics
– Contribute to retirement accounts that grow over time
Do you have collateral to secure the loan?
For many loans, banks look for collateral – an asset that becomes security for the loan in case you were to default. The collateral provides the bank an alternative source of repayment.
Common assets used as collateral include:
– Real estate – For mortgages and home equity loans
– Cars or boats – For auto loans
– Business equipment – For commercial loans
– Investment accounts – For securities backed loans
– Insurance policies – For insurance loans
If you were unable to make payments, the bank could seize and sell the collateral to recoup their money. This reduces their risk of not being repaid on unsecured debt.
Having assets to pledge as collateral provides assurance and makes approval more likely. Even better if the collateral is worth more than the loan amount borrowed. It shows you have skin in the game.
For unsecured loans like personal loans or credit cards you have no collateral, so strong income and credit scores are even more important.
Tips for using collateral to secure better loan terms
– Use available equity in your home for a HELOC or cash-out refinance
– Purchase investment assets that could be used as collateral for future loans
– Pay down loans against your assets to maximize remaining equity available
– Carefully research asset values and have professional appraisals done
– Only use collateral you are comfortable potentially losing as last resort
What is the purpose and type of loan you need?
Banks will look at why you need the loan and the type of loan being requested. Loans for productive purposes that generate income or build assets are favored.
– Mortgages to purchase or improve real estate
– Business loans to expand operations
– Student loans to enhance education and skills
– Auto loans to purchase reliable transportation for work
– Debt consolidation loans to reduce high-interest payments
Refinancing existing debts at lower rates is also viewed positively as it reduces monthly payments.
Higher risk loan purposes include:
– Borrowing to pay off unsecured debt like credit cards
– Vacation loans
– Borrowing for a hobby or recreational purchase
– Taking cash out home equity for discretionary spending
The applicant’s intended use of funds provides insight into their financial responsibility. Do they use credit judiciously to grow assets? Or do they overextend for unnecessary consumption?
Banks also look at the specific loan program. Government insured loan types like FHA and VA mortgages represent less risk than subprime programs. Qualifying for conventional financing suggests stronger credit and finances than specialized lending.
Tips for positioning your loan purpose favorably
– Use loans to build assets and income like education, real estate or a business
– Pay off high rate debt and consolidate into a new lower cost loan
– Be ready to clearly explain your reasons for borrowing and how you will repay
– Avoid borrowing for lavish vacations or purely discretionary purchases
Conclusion
When reviewing applications, banks analyze many aspects of your financial situation, profile, credit background and the loan specifics to control default risk.
Favorable factors that can help you qualify include:
– High credit scores with positive history
– Low debt-to-income ratio
– Steady employment and income over time
– Significant assets and emergency savings
– Available collateral to secure the loan
– Minimal recent credit inquiries
– Smart intended use of loan proceeds
Loan approval is more likely when you optimize as many of these areas as possible in advance. Maintaining solid financial habits over time is key. A strong application puts lenders at ease and demonstrates you are a lower lending risk.
With prudent use of credit, diligent savings and financial discipline, you can build a healthy profile that shows banks you deserve financing and will repay responsibly.
