Customers call or stop by my office and often ask “How do I know if I will qualify for a loan?” While each individual situation is unique, there are three main factors that are evaluated and used to determine whether or not a bank extends financing to an individual: credit score, debt to income ratio, and affordability of the property/down payment.
Your credit score is made up of information pulled from your credit report. A formula is then used to calculate a number ranging from 350 to 850 using the following information:
- Payment history: Your account payment information, including any delinquencies and public records.
- Amounts owed: How much you owe on your accounts. The amount of available credit you’re using on revolving accounts is heavily weighted.
- Length of credit history: How long ago you opened accounts and time since account activity.
- Types of credit used: The mix of accounts you have, such as revolving and installment.
- New credit: Your pursuit of new credit, including credit inquiries and number of recently opened accounts.
Federal law mandates a customer’s right to a free credit report annually, but not a free credit score. You can request a free credit report, and use that information to estimate a potential score, by visiting www.annualcreditreport.com.
Debt to Income Ratio
Your credit report can also help you determine your debt to income ratio, another factor used when qualifying customers for a loan. The debt to income ratio ensures that the borrower has enough income to cover their existing debt payments as well as the added expense of the new loan. As a rule of thumb, you debt to income ratio should not exceed 43%. In other words, all your annual debt expenses should not make up more than 43% of your annual income. If your ratio is above the suggested benchmark, it’s recommended that you try to pay off some of your existing debt. A great place for information on ways to pay off and manage existing debt can be found at www.consumer.ftc.gov.
Affordability of the Property/Down Payment
When determining whether or not a customer will qualify for a loan, the availability of down payment funds and overall cost of the house are also evaluated. The purchase price of the house determines the down payment, the amount paid out of pocket. You can often lower your monthly payment or afford a more expensive home by putting more money down. If the down payment amount is less than 20% of the purchase price, then you may have to purchase private mortgage insurance (PMI), which is an added cost. The affordability of a property is important to keep in mind when shopping for a new home because credit score and debt to income ratio won’t qualify you for an expensive house on their own.
While your credit score, debit to income ratio and affordability of the property/down payment are all evaluated when applying for a loan, each lending situation is unique. It’s important to have open communication with a knowledgeable loan officer to help guide you through this process.
Robin Daniels is Asst VP/Secondary Market Manager for Peoples Bank & Trust Co.