The capacity to repay loans is a fundamental aspect of the lending process, especially for non-credit card revolving credit lines and traditional loans. Unlike credit card approvals, where a strong payment history and good credit rating may lead to increased credit lines without much consideration of capacity, loans require careful assessment of one’s ability to repay.
Even subprime lenders, who have a higher risk tolerance and may permit higher debt ratios than banks, still prioritize capacity evaluation. While their risk appetite is greater, they remain cautious, particularly when it comes to capacity considerations.
When applying for a loan, lenders calculate a borrower’s debt ratio, which includes the loan payment, to determine whether they possess reasonable means to repay the loan. Although individuals allocate their income differently—some living more frugally than others—debt ratio calculations are based on standardized norms and assume responsible financial management, often influenced by one’s credit history.
A positive credit history, free of late payments, demonstrates the ability to manage non-debt repayment spending and implies a certain level of responsibility towards debts, reassuring lenders of the borrower’s future financial conduct.
Nonetheless, lenders must ensure that the borrower’s debt obligations remain manageable. Debt ratios provide some leeway, but banks generally aim to avoid situations where debt payments and housing costs exceed 40% of the borrower’s gross income. Subprime lenders may permit slightly higher ratios but avoid excessive levels to minimize default risks.
It’s essential to differentiate between fixed and necessary costs, such as debt payments and housing, and discretionary spending, which can be adjusted according to the borrower’s financial situation. For instance, if someone faces financial difficulties, they can cut back on discretionary expenses, like eating out, and make necessary adjustments to ensure their debts are prioritized and repaid on time.
One’s Credit History
A person’s credit history plays a crucial role in the loan approval process, particularly for unsecured loans from prime lenders like banks. Lenders carefully examine an individual’s credit history over the past 6 to 7 years (varying by jurisdiction and credit reporting agency) to assess their creditworthiness. To qualify for favorable interest rates and terms, having a clean credit history is essential, among other factors.
Defaults or any negative marks on the credit history can significantly impact a borrower’s chances of obtaining an unsecured loan from prime lenders. Lenders are cautious about extending credit to those who have experienced issues in the past, as they are more likely to default, posing a risk that lenders are not comfortable with.
Late payments on the credit report can also hinder borrowing from prime lenders, although the impact may lessen over time. If a considerable amount of time has passed since the late payments occurred, it might still be possible to qualify for a loan.
Credit scores are based on statistical models that assess the probability of a borrower defaulting. A higher credit score indicates a lower likelihood of default, and vice versa. Consequently, unsecured credit is often priced based on the credit score category, with the best scores receiving the best rates, while other good scores might get slightly higher rates. There may also be a threshold where the credit score does not meet the minimum requirement for loan approval.
Another critical factor affecting credit score risk is the percentage of available credit used, especially in the context of revolving credit lines. This factor is separate from the capacity to repay loans. Higher utilization of available credit has a negative impact on one’s credit score. Lenders view individuals with maxed-out credit as higher default risks, while those with low or no utilization are considered less likely to default. The utilization of available credit is associated with higher risk, which influences the credit score calculation.
The Concerns of Lenders
Responsible credit usage, which includes using credit products less or not at all, is viewed more favorably by lenders. While some may believe that using credit frequently and paying it back on time helps boost their credit score, lenders actually value restraint and responsible credit management more.
One of the concerns lenders have is that borrowers may take on additional credit products and overextend themselves after obtaining a loan. Demonstrating discipline in credit usage is highly valued and considered a measure of the borrower’s riskiness in lending decisions.
Lending in the banking industry operates on tight margins, especially when compared to other sectors. To make a profit while keeping default rates low, loans are priced based on risk, and one’s credit history plays a pivotal role in securing a loan and obtaining favorable rates.
Different lenders may have varying risk tolerances reflected in their rates. Some lenders, charging higher rates, may cater to individuals with higher default risks who may not pay back their loans in full.
The primary concern for lenders is that borrowers repay their loans as agreed, and they use statistical models to evaluate this. To ensure approval, borrowers should ensure their credit profile aligns with the lender’s criteria.
Simply having a clean credit history is not enough; a positive credit history with sufficient depth is also crucial to prove creditworthiness. Interestingly, having just a single credit product is sufficient for one’s credit score, and having more may actually have a negative impact. People who default on loans tend to have more credit facilities open than those who do not. Therefore, it’s prudent to limit the number of credit products to what is genuinely needed.
While thicker credit files can slightly bring down credit scores, having a reasonable number of credit products that have been open for a while is generally preferable. Lenders may consider the thickness or thinness of one’s credit file when evaluating credit history. A thicker file, but not excessively so, may be seen as more favorable, as long as the credit products have been open for a significant duration.
Credit scores do not penalize shopping around for credit within a short timeframe, like within 14 days, but excess credit inquiries and newly opened credit products can raise red flags and suggest a need for credit, which might impact one’s score.
Even with a very good or excellent credit score, certain types of loans, particularly mortgages, may require a thicker credit file. Banks may be more cautious about lending substantial amounts to individuals who have only proven themselves with limited credit history, such as having a single credit card. Demonstrating responsible credit usage and maintaining a positive credit history can significantly improve one’s chances of obtaining favorable loan terms and approvals.
Getting Your Approval
In the digital age, loan approvals have become increasingly efficient, with some applications being adjudicated in a matter of seconds. Computer programs are set up to evaluate loan applications and deliver either a yes, no, or maybe response. If the application is deemed sufficient and fits within predefined criteria, instant approval is provided.
However, there are cases where the computer system might not account for certain variables or may find the application to be borderline. In such situations, the application may be referred to a human adjudicator for a more in-depth review. The human adjudicator has the flexibility to consider additional factors and may approve the application, which is the only way to get approved if the computer system initially declines it.
Loan approvals typically depend on pending income verification, where applicants need to provide documents to substantiate the income reported on their applications. If the verified income differs significantly from the reported amount, the application may need to be requalified. Depending on the extent of the difference, approval status may be affected.
Loans, whether installment loans for specific purposes or revolving loans that provide on-demand borrowing capabilities, can be valuable tools for managing personal finances and enhancing one’s lifestyle.
Having a good understanding of how lenders evaluate loan applications can put individuals in a better position to meet their requirements and increase the likelihood of approval or obtaining the desired interest rate. Being aware of how lenders perceive applicants and knowing how to present oneself in the best light can contribute to a more successful loan application process.
