Your Credit Score vs. Your Ability to Repay
A credit score is a three-digit number that lenders use to evaluate the risk of lending you money. It is based on your financial history and it forecasts your ability to repay debt in the future. If you have a high credit score, you're considered less risky of a borrower than someone with a low credit score.
Having a high credit score shows that you have a history of being a responsible borrower and that you can properly budget to repay your debts on time. With a high credit score, lenders are more likely to approve you for a loan and offer you more favorable interest rates and terms.
However, your credit score is not the only factor lenders use to determine if you can earn approval for a loan or line of credit. The amount of the loan or line of credit you are requesting can require measures beyond your credit score to assess if you can repay the loan. Here's how lenders use other factors to figure out if a loan is right for you.
How Lenders Determine Your Ability to Repay a Loan
While most lenders will look at your credit score when deciding whether or not to approve you for a loan, they'll also consider five other factors including:
As reflected through your credit report, your credit history shows lenders how you have made or not made on-time payments towards your credit accounts — through credit cards, loans, or other regular bills. A positive credit history shows lenders that you have paid back your debts on time and increases their chances of approving you for new credit. Most credit histories will look back at your past seven years of credit use.
Many lenders will want to know what the loan will be used for, to understand the purpose of the loan — especially as the conditions for an auto loan will be very different than the conditions of a home loan. If you have a long and stable employment history, a long-term loan of ten years or more will seem reasonable to a lender, but if you have a history of changing employers, a lender may find it risky to offer you a loan that must be repaid over a longer time period.
Your capacity is your ability to repay a loan based on your current income, employment history, and outstanding debts. Often, lenders will use the debt-to-income (DTI) ratio to get a sense of your capacity to take on more debt. To calculate your debt, add up any regular bills including rent or mortgage, credit card payments, loan payments, and education bills; to calculate your income, find your gross monthly income (what you are paid before taxes are removed). Dividing your debt by your income provides your DTI — and typically lenders prefer to see your DTI below 40% before they will consider offering you additional lines of credit.
The amount of money you put toward your loan or your down payment represents a contribution of capital. While a down payment can reduce the amount you owe on your loan, driving down your monthly payments and interest rates, it also acts as a security for prospective lenders. When you can provide capital in advance of a loan or line of credit, your lender can more easily assign approval.
Assets that the lender can repossess — like your house or car — if you default on a loan provide another security against your potential default. By providing collateral, you significantly lower the lender's risk, which improves your changes for approval. Collateral can also drive down interest rates on the line of credit.
Even if you have a high credit score, these factors may suggest to a lender that you are not able to repay the loan that you are applying for — even with a credit score of 800, your current job with a salary of $75,000 wouldn't suggest that you could pay off a million dollar loan, right?
Know Your Own Ability to Repay
When you build a budget, you can find out exactly how much money you could potentially put towards a loan each month. If your budget says that you can't afford the monthly payments, you should avoid applying for a loan or a line of credit.
A lender stays in business by offering the highest amount of loans to those that lenders can be assured will repay the entire loan. Your credit score and other factors may tell lenders that you can take out a bigger line of credit than you actually need — pushing their risk on you. Instead of taking the maximum of what is offered to you, consider first what you can afford to repay each month and build your loan or credit application around your terms, not theirs. You stay in business only by accepting loans that match both your needs and your available funds.
By practicing careful consideration when you apply for a loan or line of credit, you are ensuring that your future credit history is only ever populated by safe bets and comfortable credit.