There are two different ways that banks price loans. The first type of approach is that every customer gets the same interest rate, provided that they pass the bank’s credit score. A credit score is basically an analysis of the risk of lending to you. It looks at various factors, including previous lending history. The second approach (sometimes referred to as risk-based pricing) is to vary the price at which the bank is prepared to lend to you, depending upon your credit score. It is this type of loan that we are considering in this article.
Risk-based pricing means that the bank will look at your credit score and, based on how many points you’ve accumulated, will decide what interest rate to offer you. The best lowest risk customers (who have the highest credit scores) will be offered the lowest interest rates, to reflect the fact that there’s a lower risk of them defaulting on the loan. Sadly, for those judged higher risk, the offered interest rate will be much higher. It is perhaps ironic that by charging high risk customers a high interest rate, the lenders may actually be increasing the probability of the customer getting into trouble on their repayments.
Banks jealously guard the factors that they use to determine their credit score and the exact criteria may vary from bank to bank. However, there are some core elements that you would expect to be used when they build up their picture of your creditworthiness.
1. Your previous credit history.
Banks will conduct a credit check when you apply for a loan. This will fire off a request to an organization such as Experian, who will then respond securely to confirm whether you have existing loans, credit cards, etc and (if so) whether you have ever defaulted on them.
It’s worth noting that it can be a good thing to have some existing debt. A lender will be more comfortable lending to someone who has displayed a previous capability to pay back debt than they will with someone who has never had any form of debt. This is why it can be very difficult for young people to get their first loan or credit card.
2. Details of your existing credit cards.
Connected to the above point, lenders will usually ask you to declare which credit cards you have and how much is outstanding on them. One of the mistakes that applicants sometimes make is to lie on their application form. This will flag up a discrepancy when the lender conducts the online credit check and will see the applicant marked down.
3. Have you ever been declared bankrupt.
Nearly all loan applications will ask a question along the lines of have you ever bee bankrupt?’ Sometimes they will include additional confusing words such as sequestrated’ but basically it all amounts to the same thing have you ever been in such a bad way financially that formal bankruptcy had to be invoked. If you tick the yes’ box for this question, then you can expect to be marked down on your credit score. One mistake that some applicants sometimes make is getting confused with being broke’ and being bankrupt’. This question is only interested in formal bankruptcy!
The credit score may take account of your income, as it is a factor in determining whether you can afford to repay the amount that you are asking for.
5. Expenses / Liabilities
Sometimes the application form will include a heading marked Liabilities’. This is bank jargon for expenses and you will be asked to state what your monthly outgoings are on things such as your mortgage or rent, your existing loan repayments, etc. As with the income figure, this will help the lender to assess your capability to repay the loan.
There may be other factors that the lender will look at. For example, an Electoral Roll search may be used and sometimes a person’s credit score can be tainted unfairly by the bad creditworthiness of other people living at an address. I’ve heard of an instance where a student ran up large debts and then his dad, who was an affluent doctor, got turned down for a credit card. The problem arose because shared the same address and the same surname!
It can be worth requesting a copy of your credit report to make sure that it is correct and that you are not getting marked down for things that aren’t correct. You can also improve your credit score by managing your checking account responsibly for a period of time. Generally, for example, banks suggest that applicants wait at least three months before reapplying for a loan if they have been declined. In that period, they would be looking for you not to go into an unauthorised overdraft and not to miss any payments on any existing borrowing.
Finally, it may be possible to get a lower rate by opting for a secured loan rather than an unsecured loan. The difference is that with a secured loan, if you default the bank will claim the asset that you have used to secure’ the loan. The downside of course is that losing that asset could be a heavy price to pay if you get into unexpected financial difficulties just ask America’s sub-prime mortgage victims for their experience of this!