What Interest Rate Do You Deserve?
Spoiler Alert! You don’t actually deserve a good interest rate.
Wow. Harsh, right? The truth is, what you think you deserve and what you are qualified for are two different things. So, let’s break it down, shall we?
What Is A Loan?
When you apply for a loan, you are essentially asking for someone else’s money. That’s right. Some nameless, faceless Joe is taking a chance on you. Imagine lending your hard-earned money to a complete stranger. Pretty scary thought, right? There’s a decent chance they’ll take your cash, pack their bags and split to Costa Rica. Even if they do pay you back, the time it takes them to do that is time your money could have been in the bank earning interest.
So, when it comes to borrowing money from someone you don’t know, they assume all the risk. So they get to call all the shots. Interest rates serve as a three-pronged strategy to ensure that you’ll pay the loan back in a timely fashion, that they’ll make some profit from giving you their money and, if you peace-out with their stacks, they’ll have made enough profit from other successful loan agreements to cover their loss. Lending is just straight up risky business, (minus Tom Cruise sliding across the room in his underwear. Bummer).
What Is A Credit Score?
That’s where your credit score comes in. Lenders need some sort of litmus test to decide if you are reasonably trustworthy enough to give their cash to. It’s like a report card on your ability to keep promises about money. The higher the score, the better you are at keeping your word. The lower the score, well, you get the picture. If your score falls below a certain threshold it means you’re pretty terrible at handling other people’s money. This leads to higher interest rates or rejected applications.
The 5 C’s Of Credit
So how do lenders determine if they’ll take a chance on you? It’s not just about how much money you make or your credit score. A lot of people are surprised to find they’ve been turned down despite making a six-figure income or never missing a payment. Lenders typically look for the “5 C’s of Credit.”
Character
Capacity
Capital
Collateral
Conditions
Character: When it comes to your character, your application will start to paint a picture of your financial personality. For example, lenders at how long you’ve been at your address. Frequent address changes signal instability and problems with landlords or mortgage lenders. Frequent job changes make lenders especially nervous. They depend on your gainful employment to repay the loan. Too many previous employers could mean you have a problem holding down a job.
They also look at how many other loan products you have, the outstanding balances and your payment history. Do you have missed payments? Why? Are your credit card balances at or near their limits? Why? Do you have a line of credit, car loan, student loans? The latter are normal and expected on credit reports. Several maxed-out credit cards, however, signal money mismanagement and a higher risk of default.
If your loan application requires you to speak to a lending specialist or visit a branch, this is all part of evaluating your character. Did you show up on time, clean and dressed well? Good, it means you’re taking this process seriously. Were you late, rude, standoffish or evasive when answering questions? This could signal a fraudulent application or could just mean you are a jerk.
Pro Tip: your demeanor could determine how much you are approved for, or even if you are approved. Someone who is difficult to give money to is impossible to collect money from.
Capacity: This simply means your ability to pay back the loan. Lenders use what’s called the Debt-To-Income Ratio which measures your total monthly income against your total monthly payment obligations. Lender’s typically like to see about 35% of your monthly income left remaining after all your debt payments are made.
If your left-over income is too low it means you cannot afford to take on another monthly payment. You likely won’t be approved. Even if you have a spotless repayment history, lenders are not going to give money to someone who does not have enough room in their monthly budget to pay it back. This is for your protection too. It would be pretty gross and predatory for a lender to knowingly give you a loan you cannot afford. They’ll have to pursue legal action against you to collect on that debt later. They lose money and your credit file gets destroyed. It’s a no-win situation.
Capital: This refers to savings and other assets that make you ̶s̶a̶f̶e̶r̶ ̶b̶e̶t̶ more attractive applicant. For example, when it comes to personal loan applications, how much of your own money do you have laying around? Do you have registered investments? A savings account? Yes? How much is in there? What are you saving for? Lender’s love to see applicants with capital because it shows them you are financially literate. You understand the importance of saving and working towards future financial goals. Go you!
It also means you have cash on hand to repay the loan should something unforeseen happen like a major illness or job loss. You’re basically Tom Cruise in his underwear and lender’s love watching you slide across the room singing “Old Time Rock n’ Roll.” So hot.
Collateral: This refers to physical assets, or items, with decent value that you can use to secure your loan. Securing the loan means it is backed with a physical item that the lender can take. For example, car loans are secured with a car and mortgage loans are secured with a house. Lenders can offer lower interest rates on secured loans because they have the security of knowing that if the loan goes south, they can take your car or house and resell them to recoup their losses.
Collateral secured loans are quite a bit safer for lenders because it shows them you have some skin in the game. If you need a car loan to buy a car to get to work, you are far less likely to miss your car payment. Doing so could result in your car being repossessed and losing your job. If push comes to shove, you’ll likely skip a credit card payment in favor of your car payment (ps. Don’t actually do that, though. That’s the “hold my beer” of bad financial decisions).
Conditions: This refers to the nitty gritty specifics. What are you using the loan for? How much have you requested? What is the interest rate and the repayment period? For example, a lot of institutions will not give loans for use as home purchase down payments. They are too risky. On the flip side, many are happy to give Home Equity Lines of Credit to existing homeowners for renovations and upgrades. Increasing the value of your home is good for you and the bank. #winning. Conversely, lenders will be a little more critical of your file for unsecured loans intended for consumer purchases for things like trendy electronics, furniture or travelling.
One More Thing To Consider
Many lenders will take into consideration things that are totally outside your control. Things like the nature of your job industry, current economic conditions, government regulations, why you need the loan, etc. You could have passed the previous 4 c’s but this is where the rubber either meets or leaves the road. Analyzing your financial condition is more of an art than a science. It really comes down to the lender’s gut feeling based on similar past profiles applied to the current context. It doesn’t mean you’ll be denied, but it could change how much you’re approved for, the term and the interest rate. Conversely, someone who barely passed the previous 4 c’s might get a glowing report here if the lender truly believes they are making a genuine effort to rebuild their credit file.
The Takeaway
At the end of the day each lender uses their own “secret sauce recipe” to evaluate you. If you get denied or don’t get approved for what you requested, do not take it personally. It's not an indictment on your actual real-life character. Don’t be afraid to ask questions. Lenders also love to teach and welcome the opportunity to coach you on how to improve your creditworthiness. Being humble and asking for actionable advice might actually tip the scales in your favor. It shows your earnestness to improve your profile. They may even start you off with a smaller loan principle and a higher rate to give you the chance to prove yourself. So don’t blow it! After all, you aren’t entitled to a loan. And you don’t actually deserve a good interest rate. Even if you have perfect credit.
Do You Need A Loan?
Show your lending institution some respect. Book an appointment. Shower, wear professional-ish clothes and show up on time. Be honest. Answer all their questions truthfully and without snark. If you already have a credit history, take care of it! Make your payments on time. Don’t carry balances on your credit cards. Live within your means. If you screw up, contact your creditors to let them know what happened and work out an action plan with them. Be humble and honest about any hiccups on your credit file. As lenders, we have literally seen it all. Believe it or not, the majority of crappy credit files we see are really just the result of bad things happening to good people. No need to be embarrassed here. You are a good person, show us that! You might not deserve a good interest rate. But you certainly deserve the opportunity to earn one.