Private lenders are well known for offering wider opportunities for possible borrowers than those from a traditional bank. But along with this ability to lend more freely comes the possibility of making a loan to someone who is incapable of paying it back, or even mistakingly making a loan to those who are not being totally honest or aboveboard. In a worst-case scenario, there is the risk of receiving loan applications that are fraudulent. As a private lender, the added risks make it even more important that there is an intensive underwriting process. Below are the major steps in the underwriting process that private lenders take before issuing a loan.
1. Checking Credit Score and Credit Card History
A credit score can be an important indicator of how financially reliable someone is. Although private lenders have much more discernment about how important a credit score is when making a lending decision, private lenders usually check it anyway. One reason is to make sure that borrowers are not applying for a loan that they do not have the ability to pay back, and a lot of this information can be discerned from a credit report.
It’s also important for private lenders to check and see if the potential borrower has active mortgages or any recent tax liens or civil judgments on their credit report. A private lender will also check to see if the potential borrower is in arrears on payments for any other loans. In the event a loan applicant is in arrears on a past loan, there is always the possibility that they are going to default on the loan they are applying for.
This is one aspect of the underwriting process where private lenders use FICO just as banks do. The FICO scoring system is quite complex. It offers a score that is related to the creditworthiness of the loan applicant. This score will give a private lender an idea of how likely the loan applicant is to default on the loan and also inform can heavily inform the interest rate charged for the loan.
2. Checking Current Debts
Private lenders want to make sure that the loan applicant does not have any hidden or expired debts. This is particularly important for private lenders to know since they don't usually have the huge safety net of financial backing that traditional lenders enjoy, so are taking much more of a risk. This most often explains the higher interest rate of a private loan.
3. Valuing Collateral
Collateral is something that the borrower agrees to forfeit if they are not able to repay their private loan. Loans that involve collateral are called secured loans while those without collateral are considered unsecured loans. Secured loans usually have lower interest rates than unsecured loans because the lender has a way to recoup its money if you do not pay.
The value of the collateral will also determine in part how much the person or entity applying for the loan can borrow. For example, when you buy a home, you cannot borrow more than the current value of the home. That's because the lender needs the assurance that it will be able to get back all of its money if a borrower is unable to keep up with payments.
4. Defining Liquid Assets
Private lenders like to see that a borrower has some cash in a savings or money market account, or assets that can be easily turned into cash above and beyond the money from a down payment. This reassures the lender that even if the borrower experiences a temporary setback, like the loss of a job, they will still be able to keep up with payments until they get back on their feet.
5. Checking Debt to Income Ratio
Closely related to a borrower's income is their debt-to-income ratio. Debt to income ratio takes into consideration monthly debt obligations as a percentage of monthly income. Lenders like to see a low debt-to-income ratio, and if a potential borrower's debt-to-income ratio is greater than 43%, it will be harder to get any kind of loan.
However, private lenders are known as risk-takers so they sometimes will still finance a loan if the potential borrower's debt to income ratio is too high. This is usually due to the applicant being in a very high-income bracket and their credit is good. Once determined that the loan applicant is in good standing with their credit cards and credit history, a private lender will usually check to see what the credit limit is on the applicant's credit cards. To determine the amount of debt that the loan applicant will have on their credit report, a private lender will ask about all of the credit cards the applicant has in their name. Although private lenders don't base all of their underwriting decisions strictly on credit scores or debt to income ratio, these are still aspects of a potential borrower's financial picture that they will want to know about.
6. Verifying a Plan for Repayment
When the loan applicant signs the contract, they will need to provide proof of the ability to make payments. A private lender will ask for a pay stub or any other evidence of income. If the loan applicant doesn’t have a job, a private lender will need to find out how they plan on repaying a loan.
When it comes to private loans, it is often the case that the potential borrower is self-employed or living off investments. This is an exception that private lenders make that traditional lenders often will not when it comes to lending money, but that is why a private lender's rates of interest are often higher since they are willing to take more risks with borrowers and their sources of income.
7. Bank Account Verification
For a private lender to be able to make a loan, they will need the borrower's bank account number, as well as a routing number. These numbers are necessary to verify that the applicant has a bank account to deposit the amount of the loan. A private lender may also ask the applicant to provide a paper copy of their current bank account statement, as well as a copy of a passport.
Underwriting happens behind the scenes and is conducted by a private lender themselves or their underwriting department, but the borrower is heavily involved in the process. If a private lender sees the need, they might ask for additional documents and answers, such as where large bank deposits or withdrawals came from on a bank account, or for more provide proof of assets.
As this article makes clear, getting a private loan can often be easier than receiving a loan from a traditional source, but a private lender still has certain underwriting steps that are the core of their loan decision-making process.
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