Qualifying to Borrow

Once you're confident that you can afford to borrow and you've decided on the type of loan you're interested in, the next step is finding a lender who is willing to grant you credit or make a loan.

What lenders want

Lenders want to be comfortable that loans they make will be paid back on time and in full. So they use a process called underwriting to evaluate potential borrowers. Generally speaking, lenders make decisions about whether to grant loans and the rates they will charge for those loans based on a review of three specific areas of a loan applicant's financial situation. These areas are sometimes called the Three C's: credit, capacity and collateral.

1. Credit. When lenders consider your credit, sometimes referred to as character, they want to know your history of repaying previous loans. This can be a good predictor of how you will pay loans in the future. In their evaluation, they use your three-digit credit score, which is based on information in your credit report. A credit score provides a quick, objective and reliable way for the lender to assess how you will repay your loan. A higher score is a better score. In fact, the higher your credit score, the more likely you are to be approved for credit and the more favorable the rate you are likely to be offered. While there can be many different versions of a credit score, a common one is the FICO® score.

2. Capacity. Capacity measures whether you are able to take on and pay for additional debt, including the loan for which you are applying. Capacity is based on several factors including your current income, your length of time on the job and the stability of the industry in which you're employed.

One factor lenders consider important is the relationship between your income and your current expenses, including other loans. This is sometimes referred to as your debt-to-income ratio. If the lender believes your combined debt and other expenses are too high, it can hurt your chances of being approved for another loan.

3. Collateral. Finally, collateral can impact a lender's decision whether to make a loan, how much to lend and at what interest rate. Collateral is anything of value that may be used to secure the loan. For mortgage loans or home equity lines of credit, the home and/or property is used as collateral in securing a loan. For an auto loan, the vehicle serves as the collateral. Having collateral can help your chances of being approved for a loan and being offered a lower interest rate. Loans for which there is no collateral, sometimes referred to as unsecured loans, tend to have higher interest rates.

Making lending decisions

Since all potential borrowers have different financial situations and experience using credit, each may pose a slightly different risk when it comes to being able to pay back a loan on time each month or pay it off in full. This potential for nonpayment is described as credit risk.

Lenders tend to offer loans with higher interest rates to borrowers who represent higher risk, as determined by a review of the Three C's. Some reasons a borrower may have higher credit risk can include:

• Lower credit score, which can be caused by various reasons, including but not limited to paying bills late, having too much debt, limited experience with loans, previous bankruptcies or old loan balances not paid off completely and more.
• Not enough income to support the loan being requested in addition to the borrower's current debts and expenses, or income which varies greatly during the year
• Insufficient length of time in current job or working in an industry that may be considered unstable
• Not enough collateral to provide to the lender as security against the loan

In some instances, borrowers with higher credit risk may not be approved for a loan at all.