The fourth blog of our Financial Planter 2014 series, we are focusing on the “Grow!” phase focused on topics for the 'established earning' phase of life. This week our Guest Blogger, is David Weliver, Editor, MoneyUnder30.com.
Imagine you’re shopping for a new credit card. You’re a savvy consumer, so you’ve done your homework: read reviews, compared rewards and interest rates, even checked your credit score.
But armed with this information, how do you know whether a lender will approve your application? Or what kind of credit line you’ll receive?
The key is to understand not just what makes a good credit score but how creditors use data about you to make a credit decision. As it turns out, your credit score is just one piece of the puzzle.
Banks want to know one thing: What’s the risk?
Many people don’t pay back their loans, resulting in billions of dollars lost by banks every year. To stay in business, lenders must limit these losses however they can. So, when you apply for credit, the lender wants the answer to one simple question: “What’s the risk that you will not pay us back?”
Using a proprietary formula, the lender crunches the data on your application and credit report to make a best guess about your risk level. If your risk level is tolerable, the lender will approve your application. If your risk level is too high, the lender will decline your application. If your risk level is in between, the bank might offer you an account at a higher interest rate or a different product.
But what do banks look at in your credit report to determine your risk level?
It’s easy to become obsessed with your credit score. It bounces around from month to month and it’s satisfying to watch it climb as you manage your credit responsibly.
But as you think about how lenders look at your application, your credit score is the starting point, not the final word. If your credit score falls below a certain threshold, the lender may simply decline your application right off the bat. More likely, however, they’ll dig deeper and apply their own methodologies to judge your risk level.
As you probably know, paying your credit accounts on time, every time is the single most important thing you can do to build good credit. A history of timely payments leads to a good credit score and your lender will check for this, too.
But most lenders don’t just want to see that you’ve made timely payments; they want to see that you’ve been making timely payments for a long time.
The age of your accounts is an important factor in credit decisions. So even if you’ve faithfully paid a credit card and student loan for two years, you’ll be seen as riskier than someone who’s been paying on accounts for 15 years (even if he or she missed a couple payments along the way!)
This can be challenging for younger adults trying to establish credit, as there’s no way to know how long of a credit history a lender requires for approval.
Debt utilization ratio
Your debt utilization ratio is the sum of your credit card balances divided by your total available credit.
For example, if you have a $2,000 balance on Credit Card A with a $10,000 credit limit and a $1,000 balance on Credit Card B that has a $5,000 limit, your debt utilization ratio is 20% ($3,000 divided by $15,000).
When considering a credit application, lenders want to see a low debt utilization ratio. If your utilization ratio is higher than 50 percent, it sends a signal that you’re already using a lot of your available credit.
It’s important to note that you have a utilization ratio even if you pay your credit cards in full every month. Your utilization score is calculated based on the end-of-statement balance regardless of whether you pay that in full or make only partial payments.
Hard credit inquires – when a bank or company checks your credit report because you applied for credit – stay on your credit report for two years. More than one or two a year hard inquiries a year raises red flags for lenders because it makes you look hungry for credit. Most creditors will, however, see the difference between indiscriminately applying for credit and, say, shopping four or five banks for the best mortgage rate.
Employment and income
Your payment history is just that, history, so lenders want to know that you have a current source of income and will ask for your employer and monthly income on the credit application.
Some lenders require proof of income like a paystub or tax form; others do not. But even if you don’t have to prove your income, don’t expect the lender to give you a 6-figure credit line because you listed an annual income of $1 million. Lenders calculate your initial credit lines based on the age of your accounts, other account limits, and any history you have with their own company.
The best way to qualify for credit limit increases is to use and pay your account regularly and then call customer service to request a limit increase after every year or two. Assuming nothing in your credit history has changed for the worse, most companies will be happy to increase your limit.
You can’t know for sure whether you’ll be approved for a new loan or credit card before you apply, but you can improve your odds by analyzing your own credit history through the eyes of a potential creditor. Objectively, ask yourself: Do I seem like a good risk?
David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.