Last Updated on August 9, 2019
When it comes to borrowing money, there is a lot you need to be aware of before you sign on the dotted line.
1. Your approval is based largely on your credit.
Maintaining excellent credit (i.e. paying your bills on time) is key to being approved for a loan. When you are going through the approval process, the loan officer will also take into account your work history, income, other bank accounts and other debt obligations you may have. Even if you have a few blemishes on your credit, you still may be approved but you should expect to pay a higher interest rate and possibly higher fees.
If there are mistakes on your credit report, you need to clear them up by contacting the credit bureau (Trans Union, Equifax and/or Experian). It is important also that you close any unused credit card accounts and if at all possible, consolidate your credit card debt to several cards. Even if you have $0 balances on your credit cards, having many lines of credit available makes you a high-risk loan because there is nothing that says you won’t max out your accounts tomorrow. If you don’t use it, close it out.
2. Your debt to income ratio is important.
This ratio will be calculated any time you apply for a new loan. Also referred to as DTI, this ratio tells the loan officer how much debt you have in comparison to your income. Let’s assume you have $3,000/month in income and $600 rent payment, $250 car payment and $50 minimum payment on your credit card for total debt of $900. Your debt to income ratio would be calculated as follows:
Debt / Income = $900 / $3,000 = .30 or 30%.
This means that 30% of your income goes towards paying your debt each month. Please note that most banks will use your gross income (before taxes) in this calculation and the only debts that are used will be any regular monthly payments (rent/mortgage, car loans, credit cards, other loans). Your electric, cell phone, cable, etc. will not be included in this calculation. The general rule is that DTI should not be more than 36-40%. By keeping the percentage low, it ensures you have enough money left to pay taxes and other monthly bills (groceries, gas, electricity, etc.)
Many mortgage companies use what is referred to as a back end ratio and a front end ratio. The front-end ratio includes all of your debt except the proposed mortgage payment and should be less than 28% by most standards. The back-end ratio includes all of your debt including your proposed mortgage payment and should not exceed 36% by most standards. When you are pre-qualified for a mortgage loan, your mortgage officer will in all likelihood use these percentages to tell you what size mortgage you can afford. Using the same income as above ($3,000), you would qualify for total debt of $1,080/month ($3,000*36%). With a $250 car payment and $50 credit card payment, you could afford $780/month mortgage payment ($1,080 – $250 – $50 = $780).
3. Watch out for extra fees
Many financing companies, particularly if they are offering a special deal, also usually have hidden fees in the loan. They are required by law to disclose these fees but they certainly won’t focus on it. Be sure you understand all fees associated with your loan before you sign the papers. A common fee and money maker for the financing companies is credit life insurance which pays off your loan in the event that you die. It is expensive coverage and in most cases is not necessary. Remember that nearly all fees are negotiable but they won’t budge if you don’t ask. Question the fees! All loans are required to disclose the interest rate along with the APR. The APR calculates an interest rate including all of the fees associated with the loan. If there is a big difference between the interest rate and the APR, it means there are a lot of fees associated with the loan. Beware!
4. Compare interest rates
There is a great website called bankrate.com that has daily national averages for a variety of loans. To make sure you aren’t being taken by your loan officer, check the rates here and question any differences. You may not get exactly the same rates. But if bankrate.com shows the average interest rate for a new car loan is 7% and they are charging you 12%, you need to find out why.
Research before you make any big purchasing decision and don’t be shy about checking around for the best deal. Do not, however, have everyone in town pulling your credit report to give you a quote. In some cases, many inquiries can adversely effect your chances to be approved as it can appear you have been turned down by those who have inquired about your credit.