A guide to what lenders consider when you apply for a loan
Before you apply for a loan, it's helpful to view yourself from the lender's perspective. This can help you anticipate what's most important for approval, and you may be able to take steps to improve your chances of success.
Lenders evaluate your application based on your ability to repay because they don’t want to lose money. They use several factors to determine whether or not they will give you a loan (and at what rate).
Your history of borrowing money and repaying it is one of the most important aspects of their decision process. Your credit history is the most common way lenders determine this. If you’ve had financial trouble in the past, you are a more risky borrower and may not get a loan or may get higher rates, depending on the lender.
Your income in another factor in your likely ability to repay any loan. To figure this out, a lender might ask how much you earn, how long you've been in your current job, and more. For large loans or if you have self-reported income, like contractors, lenders may require that you provide documentation to prove your income, such as tax returns.
Next, lenders look at how much you earn and how a new loan payment would impact your monthly budget. Most times they look at your debt-to-income ratio, which shows them how much of your current income goes toward debt payments. Debt includes your monthly mortgage or rent payments; minimum credit card payments; auto, student or personal loan payments; and alimony or child support. To determine your ratio, add up all of your debt along with the new loan payment and divide it by your monthly gross (pre-tax) income.
Typically lenders look for ratios lower than 28 percent, but depending on the type of loan they will allow up to 50 percent. The further below a lender’s cutoff you are, the better your chances of qualifying for a loan with them will be.
Skin in the game
Lenders like when borrowers have a stake in their loan. This is why larger down payments get better mortgage terms and collateral earns the best rates on loans. Having skin in the game makes it more likely that a borrower will repay because they don’t want to lose what they put up. It also provides lenders a way to make up losses because they take ownership of the collateral and sell it.
Loan-to-value describes how much loan you are taking compared to the value of the collateral. Higher LTVs designate more risky loan conditions for the lender. To calculate LTV, divide the outstanding balance of loans against an asset by the asset’s value. Here’s an example.
($200,000 mortgage balance + $30,000 home equity loan balance) / $500,000 home value = 46 %
For home loans (mortgage and home equity), lenders typically don’t want borrowers to go higher than 80% LTV, to ensure they keep some value and don’t overextend their credit. With 20 percent of the home's market value as a 'cushion', lenders can stay relatively confident that they could recoup the money owed in a worst-case scenario (if the lender has to foreclose).
Lenders sometimes ask about reserves, which could help to cover payments if your income were to dry up. To see if you have a safety net, they may ask to see bank account balances, investment accounts, or other resources that you could tap if needed. If you have enough cash in the bank to cover your payments for 12 months or more, lenders are more confident that you'll repay.
Ways to improve your application
ou might not be able to improve your credit score overnight, but you have several opportunities to improve your chances of getting approved.
Check your credit: Before applying for a loan, review your credit — it's free for U.S. consumers to view their credit report every year. If there are any errors, fix them.
Mistakes can drag down your credit score or cause lenders to think you owe more than you really do. If you're behind on payments, get current so your credit reports show that you're on-track with your existing debts.
Pay down debts: Paying off loans may help you qualify for a new loan because you can eliminate (or reduce) your required monthly payments. Doing so effectively frees up cash flow and improves your debt-to-income ratio.
Make a down payment: For secured loans like home and auto loans, a bigger down payment can help you get approved at the best rates possible. As a bonus, a smaller loan balance results in a lower monthly payment (so you improve both your debt-to-income ratio and your loan-to-value ratio).
Add a cosigner: If somebody applies for a loan with you, the lender can consider the additional applicant's income and credit scores in addition to yours. Cosigning can be risky, as that person will be 100 percent responsible for repaying your loan, and that's a lot to ask of anybody.
Considering what a lender looks at when you apply for a loan can put you in the best position to not only qualify for a loan, but to get the best rates.