If you are looking to get a new loan, whether it is a mortgage, auto loan, personal loan, credit card, or something else, a bank or other lender will review and approve or decline your application.
As a former banker, I spent time tasked with reviewing loan applications that came through my branch. There are many misconceptions on how loans are approved. Your credit score is an important factor, but just one small piece of the puzzle. Let’s dive in and take a look at what banks actually do when approving your loan application.
Your credit score – the first glance
Whether you apply for your loan online or in person, the first place the bank will look is your credit score. This simple number works like your old grade point average in school. If you had a high GPA, you had good grades. If you had a low GPA, you had bad grades. Credit scores work similarly, giving a high-level view into your credit before digging into the details.
However, your credit score is just the first hurdle. Your credit score can be an instant disqualifier, but few banks will approve a new loan with a good credit score alone. There are many more steps to loan approval if you have a qualifying credit score.
Your history of payments – credit history
If your credit score is good enough to get past step one, the real analysis begins. The first step I took when approving a loan after checking the credit score was to look at the applicant’s full credit history.
My bank had a system for underwriting loans using old school paper printouts. I would print the applicant’s credit report for the loan file and would manually review with a highlighter. I would mark any late payments and tally them up to look for a pattern.
A 30-day late payment or two wasn’t a big deal, but 90 day late payments were. A pattern of late payments was enough to disqualify an application, even if they met credit score requirements.
Your likelihood of default – bankruptcies and judgements
Assuming the credit history was free of a pattern of late payments, the next section to review was the bottom of the credit report, which contains notes about any past bankruptcies or judgments.
Recent bankruptcies were an instant decline in most situations, though applications rarely made it beyond the credit score check with a bankruptcy outstanding. Judgements were very rare, but did raise an additional flag. Judgements were not an instant decline, but I did note them to follow up and learn more. In some cases, they would be enough to end an application, but that was not a hard rule.
Your ability to pay – debt to income
At this point, the credit review was essentially done, and my focus shifted to the applicant’s outstanding debt, income, and ability to pay for the loan. By reviewing the credit report, I knew at this point that the borrower was responsible with past loans and shows the habits of making on-time payments, but that doesn’t mean they can afford the new loan they want today.
At this point, I would open an Excel spreadsheet template and enter borrower information. The spreadsheet would ultimately calculate the borrower’s debt-to-income (DTI) ratio, a calculation that shows the borrower’s available income to pay for the new debt.
To fill-in the file, I would enter the borrower’s income at the top and monthly payments for every loan on the credit report. For any installment loans like a student loan, mortgage, or auto loan, I would enter the scheduled monthly payment amount. For credit cards, we would use the minimum monthly payment as reported to TransUnion, the credit bureau my bank used to access applicant credit reports.
This was not always a black-and-white process, and I had to use my best judgment in some cases. If the account showed on the applicant credit report as an “authorized user,” I would assume the applicant was not required to make payments and would remove the loan from the calculation, improving their ratio. However, I did have to trust the credit report. Banks and credit card issuers typically update credit reporting monthly, so the timing of the most recent update could impact the number used for the debt-to-income ratio.
For example, if you have a card that you pay off in full every month, it does not have a zero balance all month every day. Whatever the balance was on the day the account was last reported to TransUnion was the number I used for the calculation. While you know you don’t carry a balance or make monthly payments on the card, I had to treat it as if you were carrying a balance.
At the bottom of the spreadsheet, I would enter in the new loan payment amount. This gave me the ability to look at the debt-to-income both without and with the loan. We had specific DTI requirements and used our best judgment on top of those rules when approving a loan.
Past behavior is the biggest predictor of future results
Just because a loan met credit score and DTI requirements did not mean the loan was automatically approved. My job was to act as the bank’s last line of defense against bad borrowers and bad applications.
My active time approving loans was in 2007, at the very start of what would turn out to be the nation’s second worst economic crisis in history. The Great Recession proved why loan application rules are so important. They were not just to protect the bank from losses, they were to protect borrowers from entering into financial agreements they could not afford or were not in their best interest.
How did we make this judgement? Ultimately it did come back to the credit report, but not the credit score. My boss and trainer at the bank told me that “past behavior is the biggest predictor of future results.” If someone had a history of missed and late payments, they would probably keep doing that in the future. If they had a history of on-time payments, they would probably keep doing that in the future. By finding a trend and a pattern, I would best predict how a loan would turn out.
Keep this in mind every month when you get bills in the mail. A late credit card payment may not seem like a big deal today, but that late payment will still be on your credit report six years from now. That small decision six years ago could be what disqualifies you from a buying a home or getting the best possible rates.
Let your behavior show bankers that you are a safe bet. If you always make on-time payments and keep credit card balances low, you have little to worry about. If you do have mistakes on your credit report today, make this the month when you change the trend. You can’t fix it overnight, but you alone have the power to improve your credit.
Your actions today become your history tomorrow. Build the best credit history to get access to the best loans, rates, and products. If you do, your future self will thank you.