What You Need to Know Before Getting a Loan
Originally published in 2017
Updated November 7, 2019
Loans. You might need one for a new car, house, or maybe you have a big purchase that you need a little help with. Regardless, everyone will eventually need to take out a loan for something. With that being said, there is some information you’ll need to know before you start your application.
Think of this as the first impression your potential lender gets of you. Your credit score and credit history shows them that you can, or can’t, pay your balances on time. It can also determine if you can secure the loan at a preferable rate saving you thousands over the duration of your loan.
Let’s put some numbers in the mix.
NerdWallet ran a scenario showing how a 1 or 2 percentage-point difference can save you money. Say you took out a loan for $50,000 and paid over 5 years with an interest rate of 3 percent. Over 5 years you would pay $3,906 in interest. If you take the same loan with a 5 percent rate, you would pay $6,615. That is why it’s important to know your credit history because, in this instance, a 2 percent difference could save you $2,709. Think of what you could do with that amount of money.
If you missed our in-depth discussion about credit and how your credit score is determined, you can find it here.
It’s no surprise that your income plays a large role in your ability to pay back a loan, so you’ll need to have some proof of income when you apply. Here’s what you’re going to need.
If you’re an employee, you will need to show your pay stubs, W-2, and/or a salary letter from your employer. If you’re self-employed, you need a different set of documents. Here you’ll need your tax returns for the past 2 years and possibly invoices and receipts.
Finally, don’t forget to think of all your income sources. This can be your spouse’s income, freelance work, or second job income.
Not only does your monthly income affect your ability to pay off a loan, but your monthly obligations do as well. Before applying for a loan, you need to know how these two factors work together. For example, if your monthly income is $4,000 but your expenses take up $3,900, you probably won’t be able to pay off a new loan.
Keep this in mind because a loan application might require you to put in certain obligations like existing debt and your rent or mortgage payments.
While this is primarily taken into consideration when you’re applying for a mortgage loan, it’s helpful to be aware and know how to calculate your debt-to-income ratio (DTI). What is it? This is the amount of debt you currently have compared to your overall income.
It’s usually calculated in a percentage. Simply add up your monthly expenses and then divide that by your monthly gross income. The rule of thumb is that your debt-to income ratio should be 36 percent or lower. In addition to your credit score, your DTI will let lenders know if you’ll run into any issues with repaying the money you borrowed.