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When you apply for any type of credit, be it a loan, credit card, or mortgage, the creditor (loan officer) will perform a very thorough analysis to determine your credit worthiness. Ultimately, their job is to determine the type of borrower you are, and the probability that you will pay back the credit that they extend to you. Today’s institutional lender uses sophisticated statistical methods and numerical models that rely on information you provide as well as information contained in your credit reports.
While it’s difficult to determine your credit risk from a single number, your risk becomes clearer when compared to others in the statistical data set (i.e., millions of consumers). The loan officer’s job is to obtain and verify an enormous amount of information that you provide, including your employment status/history, the amount of debt that you have, your spending habits, your income, your assets (net worth), and your credit scores. In the sections that follow, we discuss some of the specific components of the lender’s decision-making process. I strongly recommend that you gather all the required documentation before you approach a potential lender; it will save you a lot of time in the long run.
What is the loan officer looking for?
• Repayment history and treatment of previous credit accounts
Any loan officer or potential creditor will want to see that you have obtained credit in the past and repaid (or are paying) all obligations as agreed. Your credit application may ask about previous credit relationships, but more likely than not, your loan officer will gather the information from a credit report. Never lie on your application; this is the digital age, and everything about you can be verified in a matter of minutes. All of the credit-reporting companies accumulate and store an enormous amount of information regarding your credit history and make it available to subscribers.
As you might expect, the “ideal” credit profile reveals an individual who has a lengthy credit history, made timely payments, and paid off balances as agreed. Depending upon the type of loan you are applying for, your loan officer may be willing to accept something less than ideal. Nevertheless, loan officers do not want to see chronically late payments, collection efforts, charge-offs, repossessions, and bankruptcies. Some lenders use nothing more than your credit report to make a decision regarding your loan application.
Tip #1: You can correct derogatory credit that appears erroneously on your credit report.
• Ability to repay your requested loan or credit line
A loan officer will want to ensure that you have sufficient income to repay the loan, among other factors. Job security is obviously a significant factor, as is your job history and the length of time with your current employer. Although your current income may be impressive, how long have you had that level of income? How long will you keep it? Furthermore, the amount of debt that you have in relative to your income is a big factor for determining your credit risk. We will discuss debt to income ratios in the next section below.
Tip #2: If your income is insufficient, some loan officers will condition your loan by proposing that you borrow less. They may also suggest that you make payments over a longer period of time to lower monthly payments.
• Amount and stability of income
Lenders use something known as a debt to income ratio (DTI). Historically, most bad credit (sub-prime) lenders require a max DTI of 50%. If you have very good credit scores, then your ideal, maximum DTI is usually 40-45%. This means that 40% to 45% of your income is used to pay debt obligations, leaving plenty of room (55% to 60%) to live comfortably on and support your family. If you have a very high DTI, then it is a clear sign to the lender that you spend beyond your means and that you may struggle to meet your credit repayment obligations each month. So your income amount and stability (length of time that you’ve maintained your income levels) are crucial components of the lender’s decision-making process.
Note: Your lender cannot consider the source of your income when determining your creditworthiness, only the amount and stability. Thus, if you are independently wealthy and living on the interest and dividends from your investments, or if you receive public assistance, this income is just as favorable as income from employment, as long as it is sufficient in amount and not likely to decrease or terminate in the foreseeable future.
• Personal and employment stability
In addition to verifying your income, the loan officer will verify your employment. They will be looking for the length of time that you have been with your current employer, and the status of your job (i.e., temporary vs. permanent). The lender will submit a VOE (verification of employment) request to your company, which will provide the information above as well as a breakdown of your income over the past two to three years. The lender will pay close attention to:
- Dates of employment
- The date that you were hired
- The date you were terminated (if applicable)
- Your hourly pay rate or salary
- Your position classification (temporary vs. permanent employee)
- Past pay raises (if applicable)
• Personal factors that might influence your credit risk assessment
- Length of time at your present address?
- Previous addresses
- Do you own or rent?
- What is your mortgage/rent payment?
- Verification of mortgage (if applicable)
- Number of dependents
- Your age
Lenders want to know if you are the kind of person who stays put. They do not want to have to baby sit you and worry that the loan could go into default. They want to see that you are entrenched in your neighborhood and are likely to be there during the life of the loan.
Note: Federal regulations prohibit use of information about marital status and children in making a credit decision.
What is local “in house” credit scoring?
Many institutional lenders use “in house” credit-scoring systems to determine whether a loan will be approved or disapproved. This is a different process from the credit reports and scores provided by the three major credit bureaus. In addition to (or in lieu of) those reports, the lending institution can utilize their own software that scores your credit risk based on their own criteria. The concept is simple. You complete a loan application and then the lender fills out a standardized credit scoring sheet assigning numerical values or scores to each of your answers. This can be done by an employee or a computer. Once the sheet is completed, the numbers are added up. If they equal or exceed a minimum acceptable total score, then you may get a loan. If not, you will likely not get a loan. Again, the final decision will rest on the entire assessment factoring in the credit scores provided to them by Experian, Equifax, and/or Transunion (some lending institutions use only one or two bureaus, or they may use all three).
For their “in house” scoring, the numerical values are derived from historical data and based on the performance of similar loans. The system is faster than the traditional method of evaluating credit applications. The loan officer needs only to determine which scoring system to use and what the minimum acceptable score will be.
The number and type of questions asked by a credit scoring system may vary from lender to lender. The minimum acceptable score also varies depending upon the amount of risk a lender is willing to take. However, when used properly, the scoring system is designed to quickly identify many of the same factors that loan officers traditionally looked for when reviewing an application, such as your ability to repay the loan, your job stability, and your personal stability. Lenders will also use credit scores provided by the three major credit reporting agencies.
Caution: A fault of credit-scoring systems is their inability to evaluate special circumstances. You may be a good credit risk even though you do not score well under a particular scoring system.
Example: A young manager in a large hotel chain is transferred from one hotel location to another several times over the course of two to three years. She moves often and usually rents furnished apartments. Although she earns a good salary and has good credit, she scores poorly under most credit scoring systems because of her frequent relocations. To avoid this scenario, some loan officers individually review all rejected applications to determine whether there are independent grounds for approval.
Tip #3: Remember that you have rights. Under the Fair and Accurate Credit Transactions Act of 2003 (FACTA), mortgage lenders are required to tell you the credit scores they used in the process of providing the mortgage.