Money and You: Course Notes

The better credit you have, the more likely you are to be approved for a loan and the better terms you’ll get on a loan. Recall that your credit rating is determined by the following:

-Payment history. Lenders want to see a long history of your bill payments being made on time.

-Current loan balances. Lenders prefer to see that you have not borrowed too much money and like to see smaller loan balances.

-Credit age. Lenders like to see a lot of history with lines of credit. The longer you have been managing money well, the better.

-Credit mix. Lenders like to see a diverse history of finances. A broader range of types of loans and bills in your recent history, the better.

-Credit inquiries. Frequently applying for loans is a red flag to lenders. Try to only apply for lines of credit only when you need it.

Lenders want to make sure that you’ll be able to pay back any loan you take out. The biggest factor in being able to pay back a loan is simply being able to afford the loan payments in your budget. One way lenders measure this ability is to look at your debt-to-income ratio. Your debt-to-income ratio (DTI) is calculated as the total amount you pay on your debts each month divided by your monthly gross income (before taxes).

Note that your DTI is based on your gross (before taxes) income. This can be confusing, considering that most personal budgets are based on take-home (after taxes) income. For example, if your gross monthly income is $4,000, taxes are $1,000, and you pay $1,500 on debts each month. Then you have $3,000 for your monthly budget, and your DTI is\(/frac{1,500}{4,000} = 0.375\) or 37.5% A rough rule of thumb is that lenders prefer to see a debt-to-income ratio under 36%, >including the loan for which you are applying. For example, suppose your gross monthly pay is $2,000 and that you already pay $300 on student loans and $320 on a car loan each month. Then your current DTI is\(\frac{300+320}{2,000} = 0.31\) or 31%. Suppose you want a credit card. The credit card company will look at how much debt you can handle. If a “safe’’ DTI is 36 While the credit card bank may not reject your credit card application in this scenario, it is unlikely that they’ll give you a high credit limit.

For some loans, particularly long-term loans like car loan and mortgages, it is not just your current income that matters but your employment history. Jobs can come and go; lenders know this. Suppose you just landed a great, high-paying job a week ago that will allow you to afford a new car and a house. Lenders are unlikely to approve of these loans for a while. The reason is that one of the biggest reasons people lose their jobs is that they simply don’t work out. Maybe your new job turns out to be toxic for you. Maybe they don’t find your work satisfactory or you don’t survive a probationary period. Maybe the position itself was unstable. In general, people who have been in a position for a while are more likely to stay employed. So, lenders want to see stability in your employment history. Even after landing a great new job, you may have to wait a few months before taking out a loan.

As discussed earlier, collateral can act as a way to reduce the risk of lending you money. For some loans, you can put up something as collateral to make the bank more comfortable with loaning you money. For some loans, collateral is part of the loan. Your house is collateral for a mortgage. Your car is collateral for a car loan. Your house is collateral for a home-equity loan.

The purpose of the loan will also play a factor. For some kinds of loans, the purpose is clear: mortgages, car loans, student loans, etc. For others, you may need to describe the purpose of the loan, and the bank will take that into consideration. Purposes for which the bank could more reliably get their money back in case of emergencies will be seen more favorably. For example, applying for a home equity loan to upgrade your kitchen is seen as less risky; your house will be used as collateral, and the lent money for the kitchen will increase its value. On the other hand, borrowing money to buy a bunch of crypto currency would be seen as incredibly risk since the bank wouldn’t be able to recover much of its money if the crypto you buy tanks.

For each scenario, someone is rejected on a loan application. Determine the most likely reason why.