When you need a substantial amount of money for a new venture, such as home improvements or combining your credit card balances, you're likely evaluating your best personal loan choices.
TL;DR
- Lenders assess debt-to-income ratio, credit score, credit history, and reliable income for personal loan approval.
- Secured loans may require collateral like a vehicle, offering potentially lower rates but risking forfeiture.
- Improve chances by lowering credit utilization, reducing DTI, avoiding new accounts, or using a co-signer.
- Other options include home equity loans, credit cards with intro APR offers, or borrowing from friends/family.
Before you apply, consider if you're even eligible for a personal loan. We'll explore five key personal loan criteria you ought to be aware of, along with strategies to improve your chances of getting approved.
A personal loan is essentially a sum of money you borrow from a lender that you can use for various purposes, and which you'll repay over time with interest.
With a personal loan, you can obtain funds from a financial institution and repay them over several months or years through consistent monthly payments. Once approved, you'll get a single sum of money transferred to your bank account, or in the case of a debt consolidation loan, the lender might settle your existing debts on your behalf. Each monthly payment consists of a portion that reduces the original amount borrowed and another portion covering the interest accrued.
Your monthly payment depends on several elements: the sum you borrow (typically ranging from $1,000 to $100,000), how long you take to repay, and the interest rate you secure.
You can use a personal loan for nearly anything—so long as the purchase is legal. Some lenders may deposit your funds as early as the same day.
5 personal loan prerequisites to be aware of
Before you open a personal loan, keep in mind the following requirements.
Debt-to-income ratio
A crucial factor for lenders is your debt-to-income ratio (DTI), which represents the portion of your gross monthly earnings allocated to existing monthly debt obligations.
For instance, imagine your monthly earnings before taxes amount to $7,000. If you allocate $2,000 each month towards credit card balances, a car payment, and student loan obligations, your DTI would be 28.5%.
While lenders have different acceptable DTI ratios, aiming for 35% or lower generally improves your chances of getting approved.
Credit score
Banks, when granting you a loan, can't rely on a close personal connection to gauge your dependability and commitment to repaying the debt. Instead, they use a credit score, which functions as a report detailing your financial reliability.
Lenders use your credit score, which considers elements such as credit utilization, payment history, and the average age of your accounts, to make decisions. This score influences not only loan approval but also the loan amount and your specific interest rate.
Credit history
Your credit history, much like a credit score, provides banks with insight into your past and present financial obligations. A substantial credit history demonstrating consistent, timely payments and sound credit management practices significantly boosts your chances of securing a personal loan at a favorable interest rate.
Reliable income
Even with a strong current income, a lender needs assurance that these earnings are consistently received. While lender requirements differ, providing three to six months of paystubs typically addresses the bank's worries.
It's important to remember that you generally can't include household income, such as your spouse's salary, on the application unless they agree to be a co-borrower.
Collateral (for secured loans exclusively)
Most personal loans are “unsecured,” meaning you can open them with no collateral. Others may require that you provide assets to cover your loan—such as a vehicle. That way if you default on your loan, the bank can use your car to recoup its money.
While secured loans might offer the possibility of lower interest rates and easier approval compared to unsecured loans, there's a significant danger of forfeiting your collateral if you fail to make payments.
Maximizing your eligibility for a personal loan
Considering these approval criteria, here are several actions you can take to improve your likelihood of getting approved:
- Lower your credit utilization: If your credit utilization is high (30% or more), it can seriously affect your credit score. Focus on paying down revolving lines of credit (mainly credit cards) to potentially see a quick increase in your credit score.
- Reduce your current DTI: Your debt-to-income ratio is a major factor when a lender is weighing your ability to repay a loan. Lowering your DTI—again, to 35% or less— can greatly increase your approval odds.
- Avoid opening lots of other accounts beforehand: Opening multiple accounts in a short period of time can be a red flag for lenders. They may think you’re scrambling for funds. For this reason, it can be a good idea to hold off on other loan applications such as credit cards if you plan to apply for a loan in the near future.
- Use a co-signer: If your credit isn’t stellar, or if your income is relatively low, you may ask a friend or family member to cosign the loan with you. Lenders will then consider your co-signer’s credit and income in its decision. Just note that if you can’t pay your bill, the cosigner will be financially responsible for your loan.
- Open a secured loan: Although it's certainly a more significant commitment than a typical personal loan, a secured loan reduces your risk profile in the eyes of the bank. Individuals who struggle to get approved for unsecured loans might find more success by providing collateral. Nevertheless, we strongly advise anyone contemplating a secured loan to thoroughly and pragmatically assess their repayment capacity.
Other methods for obtaining loans
A personal loan is far from the only way to get money when you’re looking to finance a large purchase or pay down bills. You may also consider:
- Home equity loan: Depending on the value of your home and the equity you’ve built, you may be able to borrow considerably more than a bank would lend you in the form of a personal loan. Home equity loans often have much more flexibility with repayment terms (up to 30 years). Just note that you may experience more fees than a personal loan—and receiving your money is slower-going. Also, you need to be very sure about your ability to repay what you borrow, as your house acts as collateral. Read our guide to a personal loan vs. A home equity loan.
- Credit cards: Whether for emergency expenses or large purchases, a credit card isn’t the ideal option due to its typically high APR. However, some credit cards offer 0% intro APR for up to two years. If you have the credit score to qualify for a card with such an offer, and can pay off your loan before this interest-free window ends, you may well save more money than if you had opened a personal loan.
- Borrow from a friend or family member: Not everyone has the luxury of borrowing considerable sums from someone close to them. If it’s possible, though, this can be a smart way to avoid interest payments and approval standards enforced by a financial institution. Just note you’ll need to make a very clear agreement and stick to it, so as to fulfill your responsibility and avoid damaging the relationship.
The takeaway
When a financial institution evaluates your personal loan application, it considers your credit score and history, your debt-to-income ratio, and your income. Furthermore, for a secured loan, the bank will also assess the worth of the collateral you provide.
To improve your chances of approval, aim to reduce your outstanding debts and debt-to-income ratio. It's also a good idea to avoid opening new accounts, such as credit cards, in the period leading up to your personal loan application.
Frequently asked questions
Your debt-to-income ratio (DTI) is a personal finance measure that compares your monthly debt payments to your gross monthly income. It's important because lenders use it to assess your ability to manage monthly payments and repay debts.
The debt-to-income ratio (DTI) represents the portion of your gross monthly income that goes towards monthly debt payments. Lenders use this figure to assess your capacity to manage an additional monthly obligation.
Yes, some lenders do impose charges when providing personal loans.
Lenders sometimes impose charges for providing personal loans. These fees can include origination, administrative, or even early payoff charges, varying by institution.
What's the lowest income required for a personal loan?
Lenders have different minimum income requirements for personal loans, but the core idea is ensuring you possess the necessary income to cover your monthly payments.
Use collateral for personal loan?
You can use collateral to get a personal loan. These are called “secured” loans, and they protect the bank from losing money in the event that you default. By putting up assets like jewelry, precious metals, or a car, the bank can take ownership of this collateral to effectively pay themselves back.
The credit score required for a personal loan varies by lender, but generally, a score of 600 or higher is preferred.
To get approved for a personal loan, most lenders mandate a credit score of at least “fair”, which FICO defines as 580 or higher. Having a “good” score or a better one, typically 670 or above, can improve your chances of approval and your probability of securing a favorable interest rate.