Imagine this: you need money, you need it badly and you need it now. You have a steady monthly income and you’ve never had issues with bad credit score. You already have a few credit obligations, but you’re sure you can handle another loan as well. You submit an application while being absolutely certain the answer is positive.
However, it will be sent back with a note: "we cannot approve you for a loan“. You’re confused and disappointed. What happened? How is it possible that you – with stellar credit score – are not eligible for a loan? This scenario is, unfortunately, a daily reality for many people and you can blame one credit principle which is called the rule of 40.
What is the 40% rule?
The rule of 40 per cent is a very common principle followed by many lenders. To put it simply, the rule of 40 means that your monthly debt-to-income ratio shouldn’t be above 40 per cent. In other words, if your monthly income is £2000, all your current monthly liabilities shouldn’t exceed £800. All those lease payments, personal loans, mortgage – the monthly payments should never go over 40 per cent of your income. If they do, it’s nearly impossible to get approved by lenders, no matter how clean your credit history is. By following this rule, lenders make sure that new credit products are offered only to those who have enough money left over after paying for other existing liabilities. If all your obligations would make up more than half of your monthly income, you’d not only be depressed and upset, but you simply wouldn’t have enough money to live through the month. No lender wants to put you in such position – and that’s a good thing. Some lenders may be even stricter and may lower the percentage under 35 per cent. It’s not at all unlikely to see lenders who decline applications if the debt-to-income ratio is higher than 30 per cent.
How to get approved for a loan despite the 40% rule?
But what to do if you badly need extra cash? The answer isn’t too joyful. If you already have several credit obligations and their monthly payments tend to make up almost half of your income, then the application will most surely get declined. There is a ray of sunshine behind those clouds though. You could apply for refinancing, also called „debt restructuring“. Thanks to the refinance loan you could pay back all current liabilities which would leave you with only one obligation – to pay back the refinance loan. Often, the monthly payments of refinance loans can be significantly lower than all the small payments you did every month to different lenders. So after refinancing, you may notice your new loan makes for a lot lower debt-to-income ratio, making you eligible for new loans. Another way to go around the 40 per cent rule is to have a co-signer – perhaps your husband, mother or someone close to you would be willing to help you out and be a guarantor for the loan. This lowers the risk for the lender significantly – in case you turn out to be incapable of covering the payments, they can turn to the co-signer who would cover the payments instead. Of course, including someone dear to you in financial affairs can be a slippery road. It is said to never lend money to a friend – same applies for co-signing contracts. If things should go out of hand, you risk with not only lowering your own credit score but also with causing inconveniences to your co-signer.
What if your debt-to-income ratio actually is under 40 per cent?
In the midst of filling the application, you might not even notice how you’ve accidentally left out some essential incomes or you haven’t marked your actual debts properly. To err is human, as they say. You simply might forget bits and pieces of your actual financial situation, hence you might accidentally tip the scales against yourself. And that’s why you might be left confused by the negative decision, as in your eyes – you have enough money in your pocket every month and you know deep in your heart that you would be more than capable of making the monthly payments. The lender doesn’t know that – all they know is what you submitted in your application. When submitting information about your financial situation, you should mark down all of your monthly incoming payments. Maybe you have accrued dividends, maybe you are a landlord and receive rent from your tenants every month, maybe you are working online to earn some extra cash. Don’t forget any of your extra income sources as they are crucial for creating a complete overview of your actual situation. Before applying for a loan, try to figure out your debt-to-income ratio – it might be the missing puzzle piece that hinders your chance of getting approved. If you’re sure about your ratio being lower than 40 per cent, you’re one step closer to being perfectly eligible for any credit offers.
Resources:
https://www.consumerfinance.gov/ask-cfpb/what-is-a-debt-to-income-ratio-why-is-the-43-debt-to-income-ratio-important-en-1791/
https://www.investopedia.com/terms/d/debtrestructuring.asp
https://www.credit.com/loans/loan-articles/cosigner-what-you-need-to-know/
https://www.forbes.com/sites/jrose/2017/11/02/different-sources-income/
