Lenders look at various components of your finances before making a final decision on your credit worthiness. Lenders will look first at your income compared to other debt and living expenses. This establishes whether you actually make enough to pay another monthly bill. From here, the lender looks at your credit score and credit history. If you have poor credit, you have a history of late or missed payments. A history of bankruptcy or foreclosure in the past seven to 10 years is also derogatory. As a final component of the risk ratio, the lender looks at any other assets that will serve as a lien on the loan.
The default risk ratio is used in both private and business lending. The ratio is used to predict the likelihood that the borrower will default on a loan. Lenders evaluate income-to-debt numbers in conjunction with credit history and other assets to see the overall financial health of an individual, couple or business.
Calculating Risk Ratio
Ratio and Interest
Lending money is a business where financial institutions make money on money. The profit margin is in the interest rate. Having a high default risk ratio can mean one of two things. Either you will be denied the loan because you are extremely likely to default on it or you will get a loan with a high interest rate. Even approval might require a co-signer or pledging another asset as collateral.
Cleaning Up Credit
Being at high default risk and getting denied for a loan isn’t the end of the story. You can work on cleaning up your credit to demonstrate better financial practices. For example, if you filed bankruptcy after a divorce two years ago, but have had positive payment history since then, you are more likely to get loan approval. Reducing expenses and paying bills on time won’t erase the bankruptcy but it will demonstrate that you learned from the bankruptcy process.
Co-signers are important to many borrowers in the midst of financial difficulties. Finding the right co-signer is imperative to keeping rates down. For example, you might be applying for a home mortgage and need a co-signer. Your parents have never been late on any payments and you ask them to co-sign. While they have excellent payment history, they may not have the debt-to-income ratio that helps you qualify for the loan because they took out a large home equity loan to build an addition and help pay for your younger brother’s college expenses. A good co-signer no longer has a large outstanding loan balances and is, in their own right, a low default risk candidate.