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Prospective borrowers fall into different categories. The savvy loan applicant has done their homework, spent time with a loan payment calculator to research payment amounts, and understands that APR and interest rates are two very different animals. Less informed borrowers are just happy to get the loan approval. They take what they can get.
What these two very different groups have in common are the factors that affect their monthly loan payment amounts. Lenders don’t care about the knowledge level of their customers. They may encourage further education in personal finance, but that doesn’t alter how they screen and approve loan applications. There are six factors that they look at.
Credit scoring has been around since 1956. The first formula for it was developed for business analysis by Bill Fair and Earl Isaac, the founders of FICO. Today, FICO scores are the lender standard for determining borrower risk. Applicants with low credit scores are at a higher risk and will be charged a higher interest rate and fees. That increases the monthly payment amount.
A credit score is the first level of the lender screening process. Individuals with scores of less than 550, which is considered “poor credit,” are usually denied outright. Those with higher scores get to the next level, reviewing credit history. Lenders look for on-time payments, outstanding credit balances, and negative information like late payments and defaults.
This is arguably part of the credit history review, but we’re listing it separately here because the debt-to-income (DTI) ratio is a critical number for lenders. It’s calculated by dividing the sum of a borrower’s monthly debt payments by their gross monthly income. Lenders prefer DTIs around 30% or lower. A higher DTI could lead to a rejection or a higher monthly payment.
Lenders need assurances that the borrower has the means to pay the loan back in the agreed-upon time frame (term). Having a job in the present moment doesn’t guarantee that, so they look at employment history. Applicants with long-term employment at the same company are at lower risk. Those who change jobs often are not.
Lenders may ask for collateral on personal loans if the other risk factors on this list are high. Mortgage and auto lenders offer better terms and lower monthly payments to borrowers who put up larger down payments. Putting down 20% or more with mortgages also eliminates the need for private mortgage insurance (PMI).
All loans are not created equal. An obvious example of this is unsecured personal loans and mortgage loans. They are very different. Then you have auto loans, lines of credit, home equity loans, and secured loans. These are all different, and so are the terms and conditions for paying them back. They also come with a choice of terms (24-month, 36-month, etc.).
The Bottom Line
To summarize, six factors affect your loan payment, and they are all reviewed by the loan officer before borrower approval. Lenders look up your credit score, review your credit history, calculate your debt-to-income ratio, verify your employment, and then offer terms based on the down payment, type, and term of the loan.
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