Financial institutions charge different interest rates on loans to account for the variety of risks associated with different borrowers. Most people assume that their interest rate is only based upon their credit score, but this is only one out of the three major risk factors considered when you apply for financing. We’d like to shed some light on these 3 major risk factors to help you understand what lenders care about when they make their underwriting decisions — ultimately determining if you will be approved, or declined, for a new loan.
Your credit score is meant to show lenders how you repay your debt. It is determined by a complex algorithm that takes into account how many accounts you have open, how much time you’ve spent establishing your credit history, if you pay your bills on time, and ultimately, what your risk is of defaulting (or not repaying) that debt.
As if it’s already not complicated enough, there are 3 major credit reporting agencies that all use dozens of different models in determining these scores and lenders also use a variety of those models in their underwriting decisions. Put simply, there is no one consistent credit score used by all financial institutions.
The Vantage Score was created by the 3 major Credit Bureaus as an effort to have more consistency in these scoring models. This scoring model is the one you’ve probably seen if you checked your score online as it’s the most common one used. We also use the Vantage Score in determining whether or not you will pre-qualified for an offer.
In addition to your credit score, lenders also look at your current address and employment history to determine your character of repaying a new loan.
Your Debt-to-Income, or DTI, is a snapshot of your ability to repay your debt. It’s normally calculated by adding up all of your monthly minimum payments from each trade-line plus your housing expense and dividing it by your monthly income before taxes. Many lenders look to see a DTI of no more than 50%, meaning that you have only legally committed half of your income to support your use of credit. All lenders have slightly different guidelines for judging your credit capacity, but length and type of employment play a large role in determining the reliability of your ability to pay off your debt.
In the auto-financing world, collateral directly refers to the vehicle that you’re trying to finance. Your Loan-to-Value, or LTV, is a measurement of how much you owe on your vehicle, compared to how much it’s still worth after you purchased it. If you have a high LTV, then you owe more money on your car than it’s current worth; meaning you have negative equity on your loan, commonly referred to as ‘being upside-down.’ Negative equity increases your risk factor in the lender’s eyes, because if you stop paying for your loan, then they will not be able to recover how much they lent to you by re-selling the car on the open market. Sometimes, when you have a stronger credit score, lenders will have more tolerance for a higher LTV. However, it is rare to find lenders who will approve a loan with a LTV of 120% or higher. If that’s the case, usually lenders will require you to make a principal reduction, also known as a ‘down payment,’ which will reduce the total amount financed, improving your LTV, and reducing your overall risk factor for that lender.
In conclusion, financial institutions consider your character, capacity, and collateral when determining your creditworthiness. Underwriters are responsible for reviewing these factors before making a credit decision, and all 3 C’s of Credit are equally important. Regardless of the risk factor, there is always a solution to improve your credit situation to qualify for a better loan.
