Planning to apply for a loan at the bank? Your financial situation, including your income and credit score, will both play significant roles in whether the bank approves you for a loan and the type of terms you get.
Although debt is often seen as a bad thing, that isn’t always the case when you’re about to apply for a loan. Here’s what you need to know about how debt can affect a bank loan application.
Debt Can Have a Small Positive Impact on Your Credit Score
There are five primary factors that affect your credit score. In order of significance, they are:
- Your payment history
- Your credit utilization
- How long you’ve had your credit accounts
- Your types of credit accounts and your recent new credit inquiries (tie)
Debt doesn’t matter for the first three items. You can build a strong payment history, keep your credit utilization low and build a long credit account history without taking on any debt. It can, however, benefit you in the “types of credit accounts” criteria.
There are multiple types of credit accounts you can have, including:
- Credit cards
- Lines of credit
- Installment loans
It’s better for your credit score if you have multiple types of credit accounts instead of one. For example, it would be better to have a credit card and an installment loan with your car title as collateral instead of just three credit cards. The former is a more diverse mix of accounts, which will boost your credit score.
Just keep in mind that this will be a small boost. It’s a nice little benefit for you if you currently have multiple types of debt, but it’s not nearly significant enough that it would be worth it to apply for a loan solely to improve your credit score.
Debt Has a Negative Impact on Your Debt-to-Income Ratio
The downside of debt is that it affects your debt-to-income ratio. As you can likely deduce from the name, that is how much debt you have compared to how much money you make. What lenders do here is compare the amount of your total monthly debt payments to how much money you make every month.
For example, let’s say that you have a $2,000 mortgage, $300 student loan payment and $200 in other debts that you must pay every month, totaling $2,500. You make $5,000 per month. Your debt-to-income ratio is 50 percent, which isn’t terrible, but it also isn’t below the maximum number lenders typically want to see of 43 percent.
If your debt-to-income ratio is too high, then the bank will consider you a high-risk borrower. This could result in a denial on your loan application, or you may need to pay a higher interest rate.
It’s impossible to classify debt as either good or bad in terms of its effect on a bank loan application. That will depend on your overall financial situation. As a general rule, it’s always best to stay out of debt when you can and pay down debt as soon as possible, but your debt may not preclude you from getting a loan through a bank.