Most people believe that your credit score is what determines whether or not your loan approved. While your credit score does influence your loan application, it is not the only factor lenders look at. Your credit score is an overall picture of how you have handled credit and loans in the past. It is a summary of your financial health determined by several factors that matter for underwriters.
Understanding How Your Credit Score Affects Your Loan Application
1- Automated Underwriting
Your credit score may determine whether or not your loan is automatically declined by an automated underwriting systems. Many lenders set up credit score requirements within their automated system. If your credit score is below their minimum requirement your application will be automatically declined regardless of any other factors.
2- Interest Rate
On every loan application your credit score indicates what your interest rate will be. Lenders utilize risk based lending to determine interest rates on loans. They follow the prime rate set by the federal government and then add points onto the prime rate based on your credit score. The lower your credit score is, the higher the risk they are taking with the loan. Lenders offset this risk by increasing the amount of interest they receive over the life of the loan.
Most interest rates are formulated on a tiered level. For example in order to receive the best rate your score must be above 750, credit scores between 700 and 749 are the next tier, 650-699 is the next tier and the lowest tier is 600-649, anything below a credit score of 600 would be declined.
Let’s use the example that this is for an auto loan, the best rate may be 4% for the top tier credit rating, the next tier will qualify for a rate of 5.5%, the third tier qualifies for 7.5% and the lowest credit rating tier receives the highest rate of 10%.
3- Down Payment Amount
Many lenders use credit scores as a guideline to how much down payment is need on a loan. This is only applicable to installment loans such as an auto loan or a mortgage. Lenders will use the same tier model to determine the down payment amount the borrower must make. The top tier of credit scores will have the smallest down payment and the lowest tier of credit scores will have to make the largest down payment.
4- Loan Term
Lenders may also determine what loan term you qualify for based off of your credit score. This is only applicable to installment loans such as auto loans, mortgages or student loans. Credit cards are open ended revolving accounts that are not affected in this way. If you have a lower credit score, a lender may not allow an extended auto loan term of 84 months, they may require a term no longer than 60 months. This will end up affecting your payment amount and whether you can afford the loan.
The Credit Factors That Mean the Most to Lenders
Your credit score does have an impact on whether or not your loan is approved or denied and what interest rate you receive. It also affects your down payment and even the loan term. However, a loan underwriter is much more concerned about all of the factors that contribute to forming your credit score. These credit details will indicate your overall financial health and handling of loans in the past and how these habits may affect your future.
Your payment history is the biggest credit rating factor that a loan underwriter analyzes. They look at how many delinquencies you have, how frequently you’ve made them, and how recent they were. Late payments are an indicator of financial struggle. Optimally a lender wants to see no late payments on your credit report. They are understanding of a few sporadic late payments, but they do not want to see a pattern of making late payments.
Credit Tradeline History
If you have never had a car loan, a lender may be hesitant to qualify you for a $40,000 auto loan. They like to see that you have responsibly handled a large or similar payment in the past. They do not want to plunge a borrower into a monthly installment loan with large payments of $400 when all they had previously paid was a minimum payment of $15. A loan applicant may have a credit score of 800, but have never paid on anything other than a credit card with a relatively small available balance. An underwriter may be concerned about the applicant’s ability to handle a large mortgage payment and may require a larger down payment.
Accounts Left Unpaid
Any collections, charge offs, liens or judgments reporting on your credit are a red flag to an underwriter. These balances that are left unpaid show that you still have outstanding delinquent debt. Your credit score may have improved since the time the past due accounts were put on your credit, but a lender will feel uneasy lending any money to you.
Amount of Credit Available
How you utilize your credit has a big impact on your score and how lenders view your application. It looks bad if you have 10 credit cards that are all approaching the limit. This is a sign of impulse spending and not having the cash flow to support your lifestyle. Underwriters may be concerned of whether you can handle the additional payment on the loan you are applying for.
The next time you are applying for a loan remember the difference between your credit score and your overall credit health. Understand that your credit score will determine how much you pay for a loan ultimately, but it is just one of the details in your overall credit rating. Lenders are analyzing what factors contributed to that score and whether they feel you can handle the loan you are applying for.