Loan ratings determine the terms and rates of our loans.
- Lenders assess the risk of lending money by assigning a rating to loan applications.
- Ideally, a candidate will have a high credit score and the ability to provide a healthy down payment.
- Lenders view collateral as a way to minimize the risk of a loan.
Every time we apply for a loan, the lenders assign a rating. This may not seem obvious because loan scoring is done behind the scenes, but it plays a huge role in our loan application approval and the interest rate we are offered. Here, we’ll explain how loan scoring works and what you can do to make sure it works in your favor.
What is loan scoring?
When you apply for a loan, lenders assess your application. It’s their way of assessing the likelihood of you repaying the loan. The practice is also referred to as “loan scoring”. The difficulty with loan scoring is that each lender has a different system for determining your creditworthiness. Additionally, they each use different labels for the notes.
For example, when some peer-to-peer (P2P) lending platforms assess a loan application, it is assigned a grade from A to G. A category A loan is considered low risk and a category G loan is high risk.
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A borrower with a Grade A rated loan can expect to pay a much lower interest rate than a Grade G borrower because the lender views the Grade A borrower as a low risk loan.
The point is this: the best way to get a loan when you need it and pay the lowest possible interest rate for that loan is to make sure the loan rating works in your favor. Here’s how:
1. Examine your credit score
Before applying for a loan of any kind, order a copy of your credit report from the three major credit reporting agencies: TransUnion, Equifax and Experian. You can order all three reports at the same time from a site like AnnualCreditReport.com. By law, you are entitled to a free copy of your report from each agency once a year.
Review each report to ensure there are no errors. Even minor mistakes can cause your credit score to drop. Credit reports don’t show your FICO score (the score most lenders use to determine how well you’ve managed your debt in the past), so you’ll have to find that score elsewhere.
You can pay through MyFico.com. Alternatively, most credit card companies provide free credit scores to their cardholders.
Credit scores range from 300 to 850. The higher your score, the better your financial standing and the more likely lenders are to approve your loan.
If your credit score is low, you’ll be ahead if you take the time to give it a boost. A good credit rating makes it easier to get a loan, but it can also be useful when it’s time to rent an apartment or find a job.
Once you have your credit score where you want it, be sure to check it several times a year, just to make sure nothing has changed. The first – and best – way to ensure a high rating from lenders is to present a high credit rating.
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2. Maintain low loan-to-value ratios
A loan-to-value (LTV) ratio expresses how much you owe on something relative to its value. Let’s say you buy a house for $200,000, and once you put down 20% ($40,000), you owe $160,000. If the home is worth $200,000, that means you have an 80% LTV (because $160,000 is 80% of $200,000).
Now let’s say you want to borrow money to buy a car that costs $35,000. If you don’t have a trade-in and no cash to deposit on the vehicle, you’ll need to borrow the full $35,000. A 100% LTV makes the loan riskier for lenders and can impact how they score your loan application.
To ensure a better rating, keep the LTV low by paying a larger deposit. For example, if you save up to $10,000 to buy the car, you will need to borrow $25,000. This leaves you with an LTV of around 71% and the loan is more attractive to lenders.
A low LTV loan means two things to a lender, and both factors affect how your loan is scored:
The more you put in, the more “skin you have in the game”. The more your money is invested in a purchase, the more likely you are to keep up with payments, because you don’t want to lose the money you’ve already invested.
The lower the LTV, the easier it will be for a lender to recover their loss if you stop making payments. Let’s say you buy that $35,000 with no down payment. If you miss payments and the lender needs to repossess the vehicle, chances are they won’t be able to collect what you owe. This is because a car is worth less than what you paid for when you took it out of the lot.
However, if you make a large down payment and keep the LTV low, the lender can repossess the car and potentially sell it for more than it’s owed.
Bottom line: Put your own money on the line. It makes you more attractive to lenders.
3. Provide guarantees if necessary
Let’s say you want a personal loan to remodel your kitchen. Most personal loans don’t involve collateral, but you want the best loan quality possible to keep your interest rate low, so you look for a lender who accepts collateral. Here’s how it works:
- You apply for the loan by offering land that you have inherited (or any other asset of value that can be appraised) as collateral.
- Your credit score isn’t perfect, but the lender knows there’s no way they’ll lose their entire investment if they grant your loan. This is because if you fail to make the payments, the lender can take possession of your collateral, sell it, and get their money back. Although it’s not entirely risk-free for the lender, it’s considerably less risky than lending you money without collateral as collateral.
- Your loan is approved and you determine if the interest rate offered is right for you.
Conclusion: Unless you have excellent credit, you are likely to receive a higher loan score if you provide collateral.
Loan classification is a way for a lender to predict the likelihood that it will be repaid in full. The higher your rating, the better the terms of the loan. And the better the interest rate and terms of your loan, the more money you can keep in the bank.
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