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If you've recently applied for a loan and your application was declined, it may feel like an insult. It's nothing personal, though, and there are several potential reasons for the denial.
To improve your chances of getting approved the next time, it's important to understand why you were denied and how to make the right changes to increase your odds of getting approved.
Understanding Why Your Loan Was Denied
Two primary factors lead lenders to deny loan applications: problems with credit and problems with income. In some situations, however, other factors may also contribute to the decision.
Your credit history and credit scores are primary factors lenders consider when you submit a loan application. If lenders see any significant negative items on your credit report or other red flags, they may determine that as a borrower, you're too risky to approve at this time.
Common negative items that can cause a denial include:
- Collection accounts
- Delinquent payments
- High credit card balances
- Too many recent credit inquiries
- Not enough credit history
You can also be denied if your credit score is lower than the lender's minimum requirement. To prevent this from happening again, make sure you know your credit scores and shop around for loans that are targeted to your credit range.
If you are not approved for a loan, you should receive a declination letter detailing the exact reason or reasons for the denial. Typically, the lender will disclose four or five factors (know as score factors) that led to the decision, enabling you to pinpoint the areas you need to focus on to improve your credit.
By law, you're entitled to a free copy of your credit report if a loan application is denied. The lender should provide instructions in your declination letter for requesting a free report from the credit reporting company the lender used to make its decision.
If you don't receive these instructions, you can still request your report directly from the credit reporting agency listed on your declination letter. With Experian, for instance, the Report Access page offers instant access to your report through a secure, encrypted connection.
If your lender denies your loan application based on income, two issues are the likely culprits. The first is that your income doesn't meet the lender's minimum requirement. Unfortunately, most lenders don't publish this information, so it's hard to know if your income is high enough to garner loan approval.
The other reason is that your debt-to-income ratio is too high. You can calculate this ratio by dividing your total monthly debt payments by your monthly gross income.
For example, let's say you earn $5,000 per month and have the following monthly debt payments:
- Mortgage: $1,200
- Student loans: $300
- Auto loan: $350
- Credit cards: $150
Your total monthly debt obligation is $2,000, giving you a debt-to-income ratio of 40%. If you applied for a mortgage loan, the maximum ratio to get a qualified mortgage is 43%, but many lenders prefer a ratio of 36% or lower.
With other loan types, the maximum debt-to-income ratio varies by lender. But if yours is too high, it's a sign that the lender believes you may have a tough time keeping up with all your payments.
To improve your chances of getting approved the next time you apply, work on paying down some of your debts.
Other Reasons for Denial
While your credit and income are the primary factors lenders consider, they don't tell the whole story. As such, you may be denied based on other reasons, such as your employment history, residence stability, and cash flow or liquidity problems.
While you may not have a lot of immediate control over some of these issues, take the reasons seriously and wait until you're in a better position to apply again.
Getting Denied Does Not Hurt Your Credit Score
When a lender or creditor asks a credit bureau to look at a consumer's credit report, an inquiry is posted to the consumer's credit report. A credit inquiry can be hard or soft. Almost every time you apply for credit, the lender will run a hard credit inquiry. For most people, a hard inquiry knocks less than five points off their credit score, but that little dip will not last long—24 months at the most.
Approval decisions for loans are made by lenders, not any of the three nationwide credit reporting companies, Experian, Equifax, and TransUnion. Also, your credit report won't indicate whether a loan application was denied, so getting denied won't impact your credit score in any way.
Getting a Loan When You Have Bad Credit
Whether you need money to finance a large purchase, cover living expenses or consolidate debt, it's possible to do so with bad credit.
Specifically, some lenders specialize in working with borrowers with bad credit and have less stringent credit requirements. The catch is that your interest rate will generally be higher than what you'd qualify for with fair, good or excellent credit.
Another way to borrow with bad credit is to get someone with good credit to apply with you as a cosigner. Some lenders allow cosigners to improve your chances of getting approved. Even if you can get approved on your own, enlisting a cosigner with a great credit history can help you score a lower interest rate.
Keep in mind, though, that cosigners are equally responsible for paying off the debt. So if you default, it could damage both your and their credit history.
Building Your Credit Before Applying Again
While it's possible to get approved for a loan with less than stellar credit, you may be better off waiting so you can get better interest rates and save money.
For example, let's say you want to get a personal loan for $5,000. If you have fair credit, you might qualify for an interest rate of 25%, while someone with good credit might get an interest rate of 15%. Over three years, you'd pay $2,157 in interest, while they'd pay $1,240.
If you can wait until you can improve your credit scores before applying for the loan, it could save you on monthly payments and interest charges over the life of the loan.
Regardless of the reason for your denial, focus on practicing good credit habits:
- Make your monthly payments on time. Your payment history is the most important factor in your credit score, and payments that are late 30 days or longer show up on your credit report.
- Keep your credit card balances low. Your credit utilization—your total credit card balances divided by their total credit limits—is another important factor in your credit score. If you have high balances, pay them down as quickly as possible, then keep them low going forward.
- Avoid too many inquiries. If your loan application was denied, it can be tempting to apply until you get approved. But while each inquiry doesn't have a big impact on your credit on its own, multiple inquiries in a short period can be a red flag for lenders.
- Check your credit reports. Review your credit reports regularly to make sure they are accurate. Get your free credit report from Experian here.
Improving your credit can take time. But if you do it right, you could save hundreds of dollars or more the next time you apply for a loan.
Editorial Disclaimer: Opinions expressed here are author's alone, not those of any bank, credit card issuer or other company, and have not been reviewed, approved or otherwise endorsed by any of these entities. All information, including rates and fees, are accurate as of the date of publication.
This article was originally published on December 18, 2018, and has been updated.