Applying for a loan or any type of credit can be stressful. We have put together a list of key things you should know about before applying for a loan, this information can help you qualify.
You will want to have a credit score of 580 or above to qualify for a loan and get the best rates. Lenders do make exceptions, however, a lower credit score may affect your rates and down payment. To understand how your credit score is calculated, we listed the formula FICO uses in order of importance below:
- 35% Payment History: Bottom line, it’s important to pay on time. Credit bureaus don’t consider a payment late until it is 30 days past due; however, you may pay additional fees or face penalties if a payment is received late.
- 30% Credit Utilization: Is a ratio that measures how much you owe on your credit cards and lines of credit compared to the limits. We recommend you use no more than 30% of your available credit monthly.
- 15% Credit History: The length of credit is important and the longer you have a credit card or line of credit, the better.
- 10% Credit Lines: A strong mix of credit including revolving debt (e.g. credit cards or lines of credit) and installment loans (e.g. mortgages, car, student loans).
- 10% New Credit: Refers to recently opened accounts. If a borrower opens too many accounts in a short period of time, it may indicate risk.
2. Debt-to-Income Ratio
Debt-to-income ratio — referred to as DTI — is the percentage of your monthly gross income that goes towards paying monthly debts. To calculate, add up your monthly debts and divide by your gross monthly income. E.g. $3500. (debt) ÷ $10,000. (gross monthly income) = 35% DTI.
DTI is extremely important to a lender because it indicates how much you can afford in monthly loan payments. High debt obligations make the borrower a higher risk because they may be more inclined to miss payments or default on the loan. When applying for a loan, ideally you should have a DTI ratio of 36% or less of gross income.
3. Proof of Income
In order to qualify for a home loan, lenders will need to see proof of income. Generally you should be able to afford a home that costs about 2½ times your gross annual salary and you will need to show proof of income. In addition to providing your two last pay stubs, you will also need 2 years of personal tax returns, 2 years of W-2’s, 3 months of bank statements and any stocks, bonds, mutual funds, IRA, 401k, any other investments.
The requirements are a bit different for a business loan. In addition to a good credit score and solid financial history, lenders may want to see your business plan, history of industry experience, specific qualifications, and assurance that you have the capacity to make the business successful. Also, be prepared to show 3 years of business tax returns, 3 years of personal tax returns, include applicable K-1 schedules, 2 months of business bank statements, 2 months of personal bank statements, profit and loss statement, balance sheet, and an accounts receivable aging report. If you’re acquiring a business, lenders will also review the financial history of the business including tax returns, cash flow statements, and outstanding debts. Click here to see our Financial Checklist.
4. Employment History
To qualify for a loan you must have continuous employment for at least two years. Lenders will contact your employer to confirm your employment history and to verify your salary. Being employed for two consecutive years with the same employer is the usually the minimum requirement, however, some lenders may make an exception. Therefore, if your employment changed in the last two years, then a lender may contact your previous employers as well.
The requirements change if you are self-employed. If you are self-employed lenders will want to review 3 years of tax returns and they will focus on your net income. To calculate your net income, start with your total revenue and subtract all of your expenses and operating costs. Use this figure and deduct the tax from this amount, and you will have your net income.
5. Down Payment
You should expect to put down a 20% down payment when applying for a home loan and 20-35% down payment for a business loan. Even if the home or business you are purchasing can be used as collateral, most lenders will still require a minimum of 20% down payment. This reduces the lender’s liability and proves that you have skin in the game.
Lenders will likely inquire about your assets, especially your liquid assets. They will be interested in seeing how much money you have saved to pay for the monthly payment, down payment, and applicable closing costs. They will look for cash reserves and verify how long your funds have been in the bank. If you have any unusually large deposits you will need to prove where the money came from and prove it is yours. Many borrowers move assets right before they apply for a loan and this raises a red flag to lenders because they want to confirm it’s been in the bank for several months, at least. They will also review your savings pattern and that your assets support your declared income.