We live in a world where loans can help us afford the items we need without having to make hefty initial payments for the items. People are getting mortgages to purchase their first home, car loans to have an extra vehicle for their spouse, personal loans to finance a home business, and credit cards to pay for incidentals. Providing a lender with the appropriate information will allow them to make the best decision so they can approve you for the loan that you want.
Yet, what information is used by lenders to make this decision?
Lenders will gather a wide range of data to determine whether you would be a good person to provide a loan to and who will be able to make the payments. One thing that a lender will look at is your credit report to check out your credit history. They will also verify your employment history and current income. While every lender has different criteria for loan approvals, most will calculate two ratios from the gathered information: Debt-to-income ratio and unsecured ratio.
The debt-to-income ratio provides a type of financial snapshot for the lender in determining how much debt you currently have, how much income you make, and how well you are able to pay for your bills without struggling to make payments. The ratio is calculated by taking all the monthly debt payments you have now and dividing that number by the monthly gross income you make before any deductions or taxes are taken out.
So if your monthly debt payments for your mortgage payments, car payments, and other debts equals $1,500 and your monthly gross income is $5,000, you would have a debt-to-income ratio of 30%.
Typically, you want to have the lowest debt-to-income ratio to qualify for a loan. If you have a debt-to-income ratio of around 36% or lower, then you will most likely qualify for many loan products, though some lenders will let the ratio go as high as 40% before denying a loan. Paying off some of your debts can help to lower your debt-to-income ratio and improve your credit history.
Unsecured Debt Ratio
There are two types of debt that a person can carry: secured debt and unsecured debt. Secured debt is typically a debt that is backed with some type of collateral that the lender can take if you fail to pay back the loan. Types of secured debt would include a home loan or car loan, as the lender can take your car or home and sell it to get back some of the loan amount that was defaulted on.
Unsecured debt is any debt where there is no collateral, such as student loans, credit cards, and personal loans. A lender will figure out your unsecured debt ratio by calculating all your unsecured debts and dividing this figure by your annual income and multiplying it by 100 to get a percentage. So if you have $5,000 in unsecured debt and you make an annual income of $45,000, you have an unsecured debt ratio of 11%.
Just like your debt-to-income ratio, you also want your unsecured ratio to be as low as possible to increase your chances of getting a loan. Most lenders want to see a ratio that is 25% or lower.
Increasing Your Chances of Loan Approval
Understand what your debt-to-income and unsecured debt ratios are before applying for a loan. If either is too high, seek out ways to lessen the amount of debt you carry, starting with unsecured debt. Lowering those ratios can have a large impact on helping you get approved for your loan.
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