How Do Lenders Determine If You Get Approved?
Have you ever wondered how lenders determine who and how much credit they’re willing to extend? It becomes a really interesting and important question when you start to think about getting a loan, or mortgage, for a new home. Knowing which factors go into determining a home loan can be the difference between qualifying for the loan and getting it at a good interest rate, or not. What lenders look at varies a little bit based on the type loan. For a home loan the primary focus is on the three C’s: credit, capacity and collateral. Credit is your credit or FICO score, capacity is your income or capacity to repay the loan, and collateral is actually the property itself. For a good overview of credit and how lenders use your credit score, this short video from FICO provides a good overview.
The main areas to focus on with how credit is evaluated by lenders are:
- How much outstanding debt to you have?
- What percent is that outstanding debt to your total available credit?
- How much you have in different types of accounts (credit cards, loans)?
- How well you’ve made payment of bills?
Those factors, and a few others, are rolled up into a score by FICO. The range is 350 – 850, with a higher number being a better score. In the past to qualify for a home loan you could be accepted with a much lower score. But since the financial crisis the standard has been raised. These days to get a loan you need to be roughly in the 650 range. And to get the most favorable interest rates your FICO score should be in the 740 – 760 range or higher. If your credit score falls below the optimal range for getting the best credit term or credit at all, don’t disperse – it’s not the end of the world. There are a number of things you can do to clean it up. A big factor is to pay down your current debts. Also, seeing if you can get credit limit increases on your current accounts can decrease your debt to income ratio which will have a positive impact on your credit score. Finally, credit reports from the three main bureaus can simply have incorrect information about your credit history. Pull your credit reports and examine them for errors. If there are any, there are steps you can take to get those errors removed, or you can use a professional credit repair firm to help do that work for you.
Capacity or Income
The next step in the process lenders use when determining qualifications for a home loan is to look at your capacity to repay the loan. Capacity is your income minus your current debts, or your income to debt ratio. Lenders are looking for a stable income, and usually wont include bonuses or incentive pay in what they consider income because it can’t necessarily be counted on to be paid every year at the same level. Debt would be balances on your credit cards, loans, and other mortgages you might have. The higher your debt to income ratio the great the risk for a lender. The lower the ratio the better chance you have for qualifying for a loan.
The last major piece lenders are looking for is the collateral or property. This is based on the actual home you’re looking to purchase. The lender will do an independent appraisal of the property to determine its market value. That value is used to determine how much the lender will loan on a particular house. Leanders use a loan to value (LTV) calculation, which is just a percentage of the market value of the home. Generally it’s around 80% - 90% of the home value. So if you’re looking to purchase a home with a $200,000 assessed market value, and the lender you are working with uses an 80% LTV, that means they are willing to provide a loan up to $160,000 for that home. The remaining $40,000 would be the down payment you would be expected to make.
The big three C’s – Credit, Capacity, and Collateral – are really the drivers how lenders determine who gets a loan, how much they’ll loan, and what the interest charge will be. But the lending institution looks at some other factors as well. These are less important for making their determination, but they are used to round out their assessment of you and the risk associated with you.
When looking at your employment history they want to ensure you have a steady income, and that your history reflects that as well. A long break between employment can raise a flag for the lender. Their view is that history is generally a good predictor of the future. And if your employment history is sporadic, there is a better chance in the future you could again go unemployed for an extended period of time – which would increase the difficulty in making your mortgage payments. Other considerations they might take into account are the borrowers age, and look at it in terms of how it might effect your ability to make payments in the future. How long you’ve lived at your current address, which would be an indicator of stability. If someone is constantly moving to a new place every year, that may be indicative of someone who have difficulty maintaining a home over the life of the loan. And any relationship you might have with that lending institution can be a factor. If you have other loans or credit cards with them, and it has been a positive history of managing that credit, that relationship can be a positive factor when evaluating you for a home loan. Again, these final considerations are much smaller factors in how lenders look at you as a prospective borrower. With a home loan, lenders are extending an enormous amount of credit. These final factors just provide a more well comprehensive picture of you. So you don’t need to sweat them too much. As long as the three C’s are solid you should be in a strong position when seeking a home loan.