When an individual or business applies for a loan, lenders conduct a thorough evaluation to determine the applicant’s credit worthiness. This process is crucial for lenders to properly assess the risk of lending money and the likelihood of timely repayment.
There are several key factors lenders consider when reviewing loan applications and making credit decisions. By understanding what lenders look for, borrowers can be better prepared with the necessary financial details and documentation required. This allows for a smoother application process.
This comprehensive guide examines the main criteria lenders use to establish credit worthiness for both personal and business loans.
Credit History and Credit Scores
A borrower’s credit history and credit scores are arguably the most critical elements assessed during the loan review process. The credit report provides a detailed overview of how well the applicant has managed credit accounts and repaid debts in the past. This record is a strong indicator of their future credit behavior.
Lenders obtain credit reports from the three major credit bureaus – Equifax, Experian, and TransUnion. The report documents the status of all previous credit accounts, such as credit cards, retail accounts, student loans, mortgages, and any late payments. It also includes personal details, inquiries, bankruptcies, tax liens, judgments, and collections.
Credit scores, such as a FICO score, are generated based on information in the credit report. Scores generally range from 300-850, with higher scores conveying lower credit risk. Many lenders have a credit score threshold (e.g. 620) below which they will automatically reject applications. In general:
- 700+ scores are considered excellent credit and represent good creditworthiness
- 680-699 is considered good credit
- 620-679 is fair credit
- 580-619 is considered poor credit
- Below 580 is bad credit
In addition to the score itself, lenders look at:
- Payment history – The report highlights late payments, defaults, judgments, or discharged debts. Too many late payments negatively impact scores.
- Credit utilization – This measures how much of the total available credit limits are being used. High balances close to the limit lower scores.
- Credit age – The length of credit history establishes a pattern over time. New credit users tend to be riskier.
- Types of credit – Having different types of accounts (credit cards, loans, mortgages, etc) demonstrates experience managing different credit lines.
- Inquiries – Too many credit inquiries from applying for multiple new accounts may indicate credit hungriness and negatively impact scores.
- Public records – Bankruptcies, tax liens, lawsuits, judgments and wage garnishments are red flags.
Borrowers aiming to improve their creditworthiness should focus on the following:
- Pay all bills on time each month
- Keep credit utilization low
- Demonstrate responsible use of credit over time
- Limit new credit inquires before applying for a loan
- Avoid missed payments and defaults
Having established good credit history and high scores signifies to lenders that the applicant is a low credit risk.
Income and Employment
Verifying a borrower’s income and employment is another vital part of assessing creditworthiness. Lenders want to confirm the applicant has steady employment and earns sufficient income to comfortably make timely loan payments.
Documents lenders may request to validate income include:
- W-2 tax forms
- Current pay stubs
- Personal tax returns
- Business tax returns if self-employed
Lenders look for stability in the applicant’s income sources over time. Frequent job changes, gaps in employment, and inconsistent income from self-employment may signal instability. Highly seasonal or commission-based compensation can also present challenges in repaying loans.
The lender will also want to understand the applicant’s position, years of experience, job type, and length of time with current employer. Higher-ranking positions, specialized skills, and long tenure suggest better job security. Recent graduates or those new to a career path may present more risk.
Borrowers can demonstrate income continuity by providing a written explanation for employment gaps, multiple W-2’s reflecting consistent income year-over-year, or a promotion history highlighting career progression. Tax returns for self-employed individuals should show steadily growing revenue.
Additional factors lenders consider regarding income and employment include:
- Total household income from all sources, not just the applicant
- Previous earnings trajectory – is income declining or increasing?
- Whether total income comfortably exceeds minimum debt obligations
- Likelihood of continued employment and income in the near future
- Secondary sources of income
By thoroughly documenting income and employment, borrowers can verify their ability to meet debt repayment responsibilities.
Existing Debt Obligations
Lenders carefully evaluate applicants’ existing monthly debt payments and financial obligations. An applicant may have sufficient income, but existing debt levels might be too high to take on additional borrowing.
Lenders review monthly payments associated with:
- Mortgage loans
- Rental or lease agreements
- Student loans
- Auto loans
- Revolving credit card balances
- Personal loans
- Child support
- Other obligations
These fixed payments reduce the funds available to dedicate towards a new loan payment. Lenders calculate two key debt ratios:
Debt-to-Income Ratio (DTI) – Measures total monthly debt payments relative to gross monthly income.
Loan-to-Value Ratio (LTV) – For home loans, compares the mortgage amount to the appraised home value.
Ideally borrowers want low DTI and LTV ratios. Typical DTI limits fall between 36-50% depending on the lender. LTV ratios above 80% are considered high risk for mortgages.
To improve these ratios, borrowers can:
- Pay down existing high balance debts
- Avoid taking on new loan obligations
- Boost disposable income to offset debts
- Make larger down payments to lower LTV
Keeping obligations and debt loads low relative to income allowsborrowers to qualify for additional credit.
Assets and Collateral
For secured loan products like mortgages, auto loans, and HELOCs, lenders also weigh available assets that can act as collateral. These assets provide lenders recourse if the borrower defaults on payments.
Typical assets evaluated include:
- Real estate – For mortgages, the home itself serves as collateral that can be sold to recover unpaid balances.
- Vehicles – Car, truck, motorcycle titles act as collateral for auto loans. The vehicle can be repossessed if payments lapse.
- Savings/investment accounts – Having cash reserves demonstrates financial stability and an ability to withstand emergencies without relying on credit.
- Retirement accounts – These tend to be last resort assets tapped only if no other options available.
- Business assets – Equipment, machinery, accounts receivable, etc. may be pledged as collateral for business loans.
Having appreciating assets, equitybuilt up, and liquid savings can offset higher debt burdens or riskier credit profiles. While not directly liquid, assets also give lenders confidence in the financial means of applicants.
Borrowers looking to leverage assets to obtain credit should:
- Build up equity in owned real estate.
- Maintain adequate emergency savings balances.
- Contribute to retirement accounts.
- Purchase quality assets that hold long term value.
- Keep assets properly insured against loss.
Credit Application Details
Lenders closely verify the information provided by applicants on the actual credit application itself. Any inconsistencies, inaccurate details, or misrepresentations may signify risk to lenders.
Details scrutinized include:
- Applicant personal information – Full legal name, Social Security Number, date of birth, contact details.
- Income amounts – Annual, monthly and employment details must match supporting documents.
- Assets – Stated balances, property values, account numbers should align with documentation.
- Debts – Previously undisclosed obligations or debts negatively impact risk profiles.
- Signatures and e-signatures – Check for any irregularities indicating fraud.
- Purpose and use of funds – Misaligning details are red flags.
Even minor discrepancies like address changes must be explained upfront, not caught during verification. Otherwise, it may appear the applicant is attempting to misrepresenttheir situation.
Thoroughly reviewing the application for accuracy and openly communicating any clarifications needed can prevent oversights that may jeopardize loan approvals.
- Credit history and credit scores provide critical insights into applicant risk profiles and tendencies. Favorable scores stem from responsible credit usage over time.
- Documenting steady employment tenure and sufficient income is required to demonstrate the ability to meet repayment obligations.
- Existing debts lower the capacity to take on additional loans. Keeping debt-to-income ratios low allows for new borrowing.
- Assets pledged as collateral provide security if borrowers default, allowing higher risk applicants to qualify.
- Closely reviewing applications for any inaccuracies minimizes rejection risks.
What credit score is considered good?
- Credit scores above 680 generally indicate good credit, withHow long does negative information stay on my credit report?
Most negative credit information remains on your credit report for 7 years, including late payments, collections accounts, and public records like bankruptcies and foreclosures. Some exceptions include Chapter 13 bankruptcies, which remain for up to 10 years. Unpaid tax liens can stay indefinitely until the tax debt is settled.
Does getting denied for credit hurt my credit score?
Having too many credit inquiries on your report from applying for numerous accounts may negatively impact your credit score. However, a single denied application should only moderately impact your score if you have a limited credit history. Those with established credit and low balances can likely absorb the minor hit of one denial. Limit applications to avoid excessive hard inquiries.
How do I build my credit to get a loan?
Some tips for building your credit history include: paying all bills on time, keeping credit card balances low, becoming an authorized user on someone else’s credit card, taking out and repaying a credit-building loan, and avoiding closing unused credit cards with long histories. Give your credit profile time to age and demonstrate responsible behaviors.
What documents do I need to provide for loan approval?
Be prepared with documents that validate your identity, income, assets/collateral, and obligations. This typically includes current pay stubs, W-2s, tax returns, bank/investment statements, IDs, property records, existing loan documentation, and possibly credit explanations. Supporting documents speed up the verification process.
How long does it take to get approved for a loan?
Personal loan approval can take 1-7 days, while mortgage and business loans may take 1-2 weeks as they require extensive underwriting. Having clean credit, low debts, steady income sources, and strong supporting documents helps expedite approvals. Preapprovals also quicken the process once you’ve found the property or item to purchase.