What is bank credit (short definition)
– Bank credit is the total amount of money a bank makes available for customers to borrow. It includes loans and credit lines provided to individuals and businesses. When a bank extends credit, it expects the borrower to repay the principal plus interest under agreed terms.
How bank credit works (simple mechanics)
– Banks gather funds mainly from customer deposits (checking, savings) and time deposits such as certificates of deposit (CDs). In return for using these funds, depositors earn a small interest payment. Banks then lend a portion of those funds to other customers. The interest spread (what borrowers pay minus what depositors receive) is a primary source of bank profit.
– Banks assess each applicant’s ability to repay before approving credit. That evaluation determines whether credit is granted, how large the loan or limit will be, and the interest rate and other terms.
Key terms (defined)
– Creditworthiness: A measure of a borrower’s likelihood to repay; assessed using credit reports, income, debt levels, and collateral.
– Collateral: An asset pledged to secure a loan (e.g., a house for a mortgage). If the borrower defaults, the bank can seize and sell the collateral to recover losses.
– Secured credit: Loans backed by collateral. These tend to have lower interest rates because the bank’s risk is reduced.
– Unsecured credit: Loans without collateral (e.g., most credit cards, personal loans). Higher lender risk typically means higher interest rates.
– Revolving credit: A credit facility (like a credit card or line of credit) that you can draw down and repay repeatedly up to a limit.
– Installment loan: A loan repaid by fixed periodic payments over a set term (e.g., mortgages, auto loans).
– Debt-to-income ratio (DTI): Monthly debt payments divided by gross monthly income; used to gauge affordability.
– Credit utilization: The ratio of outstanding revolving balances to total revolving credit limits; a component of credit scoring.
– APR (annual percentage rate): The yearly interest cost of borrowing, including fees if disclosed.
Types of bank credit (overview)
– Credit cards (revolving, usually unsecured).
– Personal loans (installment, unsecured or secured).
– Auto loans (installment, usually secured by the vehicle).
– Mortgages (installment, secured by the property).
– Business lines of credit (revolving; may be secured or unsecured; typically reviewed annually).
– Other business loans for working capital or expansion.
Key factors banks consider when approving credit
– Credit score and credit history.
– Income and employment stability.
– Existing monthly debt obligations (DTI).
– Collateral value (if a secured loan).
– Purpose and size of the loan.
– For businesses: cash flow, business history, and financial statements.
Practical checklist: steps to improve your chances of bank credit approval
1. Review your credit reports for errors and dispute any inaccuracies.
2. Lower revolving balances; aim for credit utilization under 20% if possible (under 30% is often still acceptable).
3. Reduce your DTI to 36% or lower by paying down debts or increasing documented income.
4. Pay all bills on time; late payments significantly harm credit history.
5. Save for a down payment or cash security to obtain secured credit if your score is marginal.
6. Gather documentation: recent pay stubs, tax returns, bank statements, and ID.
7. Shop and compare offers (APR, fees, prepayment penalties).
8. Consider a co-signer only if you understand the legal and financial risks to both parties.
Worked numeric examples
1) Calculating debt-to-income ratio (DTI)
– Formula: DTI = (Monthly debt payments / Gross monthly income) × 100
– Example: gross monthly income = $5,000; monthly debt payments (loan payments, minimum credit-card payments, etc.) = $1,200
– DTI = ($1,200 / $5,000) × 100 = 24%
– Interpretation: 24% is below the
= Worked numeric examples (continued) =
1) Calculating debt-to-income ratio (DTI) — (continued)
– Interpretation (continued): 24% is below many commonly cited thresholds; lenders often prefer a front-end DTI (housing-only) under 28% and a back-end DTI (all recurring debt) below 36–43%, depending on the loan type and lender underwriting. Lower DTI improves the chance of approval and may qualify you for better pricing.
2) Loan-to-value ratio (LTV) for secured credit
– Definition: LTV = (Loan amount / Appraised value of collateral) × 100. LTV measures how large the loan is relative to the collateral’s value.
– Example:
– Collateral (car value) = $20,000
– Desired loan = $15,000
– LTV = ($15,000 / $20,000) × 100 = 75%
– Interpretation: A 75% LTV means the lender is financing 75% of the collateral value. Many banks cap LTV for certain assets (e.g., auto loans often 80–100% for new cars, lower limits for used cars). Higher LTV increases the lender’s loss severity if collateral depreciates.
3) Monthly payment for an installment loan (amortizing loan)
– Formula (standard annuity formula):
– Monthly payment = P × [r(1+r)^n] / [(1+r)^n − 1]
– Where P = principal, r = monthly interest rate (APR/12), n = total number of monthly payments
– Example:
– P = $10,000; APR = 6% annual; monthly r = 0.06/12 = 0.005; n = 36 months
– Compute (1+r)^n = 1.005^36 ≈ 1.19668
– Numerator = r × (1+r)^n = 0.005 × 1.19668 ≈ 0.0059834
– Denominator = (1+r)^n − 1 ≈ 0.19668
– Monthly payment factor ≈ 0.0059834 / 0.19668 ≈ 0.03043
– Monthly payment ≈ $10,000 × 0.03043 = $304.30
– Interpretation: You would pay about $304.30 per month for 36 months; total payments ≈ $10,955 (interest ≈ $955).
4) Converting APR to Effective Annual Rate (EAR) with periodic compounding
– Definition: EAR (effective annual rate) accounts for compounding within the year; APR (annual percentage rate) often does not.
– Formula: EAR = (1 + APR/m)^m − 1, where m = compounding periods per year.
– Example:
– APR = 12% annually, compounded monthly (m = 12)
– EAR = (1 + 0.12/12)^12 − 1 = (1.01)^12 − 1 ≈ 0.126825 → 12.68%
– Interpretation: A 12% APR with monthly compounding yields an effective annual cost of about 12.68%.
Practical checklist before applying to a bank for credit
– Confirm your credit reports and correct errors (use official credit reporting agencies).
– Calculate DTI and simulate monthly payment impact on your budget.
– Estimate LTV if you plan to use collateral; know typical maximum LTVs for that asset.
– Gather proof of income, recent bank statements, ID, and tax returns.
– Compare total cost metrics (APR, fees, prepayment penalties, and EAR when compounding matters).
– Ask about repayment flexibility and default remedies (late fees, repossession, collection procedures).
– Consider affordability scenarios: job loss, interest-rate increases (for variable-rate loans), and emergency reserves.
How banks typically assess consumer credit (brief)
– Capacity: ability to repay, measured through income and DTI.
– Credit history: payment history and credit-mix length from credit reports.
– Capital: borrower’s savings,
– Capital: borrower’s savings, investments, and net worth that can absorb shocks or be used to repay debt.
– Character: credit score, payment history, and documented reliability (employment stability, reasons for past late payments).
– Collateral: assets pledged to secure the loan (real estate, vehicles); lenders focus on the loan-to-value (LTV) ratio and how easy the asset is to liquidate.
– Conditions: purpose of the loan and broader economic factors (industry trends, interest-rate environment) that affect the lender’s willingness to lend.
How these factors feed decision thresholds (brief)
– Lenders set DTI (debt-to-income) cutoffs for capacity. Common back-end DTI limits range from ~36% to 50% depending on loan type and risk tolerance. Front-end (housing) ratios are tighter for mortgages.
– Credit-score bands map to pricing tiers: higher scores → lower interest spreads and fewer required compensating factors.
– Lower LTVs reduce required borrower equity and often lower the interest rate or eliminate private mortgage insurance (PMI).
– Strong capital and stable employment can offset borderline credit metrics; adverse conditions (recession risk) tighten requirements.
Practical checklist before applying (step-by-step)
1. Order your credit reports from the three bureaus and correct errors (AnnualCreditReport.com).
2. Compute your DTI: include proposed loan payment in the back-end DTI simulation.
3. Estimate LTV for secured loans: LTV = loan amount / appraised value.
4. Gather documents: pay stubs (last 2–3 months), W-2s or 1099s, last 2 years’ tax returns, bank statements (2–3 months), photo ID, property appraisal (if available).
5. Get pre-approval quotes from several lenders and request written fee breakdowns (origination, underwriting, PMI, third-party fees).
6. Compare total cost metrics: APR, fees, prepayment penalties, and EAR when compounding matters.
7. Plan affordability scenarios: job loss, rate increases (for variable-rate loans), and an emergency reserve equal to several months’ payments.
Worked numeric examples (clear formulas and steps)
1) DTI (debt-to-income ratio)
– Formula: DTI = (total monthly debt payments / gross monthly income) × 100.
– Example: gross monthly income = $6,000; existing monthly debt payments = $1,500.
DTI = (1,500 / 6,000) × 100 = 25%.
If the new loan payment is $400/month, include it: new DTI = ((1,500 + 400) / 6,000) × 100 = 31.67%.
2) LTV (loan-to-value)
– Formula: LTV = (loan amount / appraised value) × 100.
– Example: loan requested = $200,000; appraised value = $250,000.
LTV = (200,000 / 250,000) × 100 = 80%.
3) Monthly payment for an amortizing loan (fixed-rate)
– Formula: PMT = r × PV / [1 − (1 + r)^−N], where r = monthly rate, PV = loan amount, N = # of payments.
– Example: PV = $200,000, annual rate = 4% → r = 0.04/12 = 0.0033333, N = 30 × 12 = 360.
Compute denominator: 1 − (1 + r)^−N ≈ 1 − (1.0033333)^−360 ≈ 0.6981.
PMT ≈ (0.0033333 × 200,000) / 0.6981 ≈ 666.67 / 0.6981 ≈ $954.83 per month.
4) Converting APR to EAR (effective annual rate) for periodic compounding
– Formula: EAR = (1 + APR/n)^n − 1, where n = compounding periods per year.
– Example: APR = 12% with monthly compounding (n =
n = 12). Compute:
Step 1 — convert APR to periodic rate:
– periodic rate = APR/n = 0.12/12 = 0.01.
Step 2 — compute EAR:
– EAR = (1 + 0.01)^12 − 1 ≈ 1.01^12 − 1 ≈ 0.126825 → 12.6825% (≈ 12.68%).
5) Converting EAR back to a nominal APR (given compounding frequency)
– Purpose: when a lender quotes an effective annual rate (EAR) but you need the stated (nominal) APR that is compounded m times per year.
– Formula: APR_nominal = m × [(1 + EAR)^(1/m) − 1], where m = compounding periods per year.
– Example (consistency check): If EAR = 12.6825% and m = 12,
APR_nominal = 12 × [(1.126825)^(1/12) − 1] ≈ 12 × (0.01) = 0.12 → 12%.
Checklist — practical steps to compare loan offers
1. Confirm whether each quoted rate is APR (nominal) or EAR (effective). If unspecified, ask the lender.
2. Note the compounding frequency (m): monthly = 12, quarterly = 4, daily = 365 (or as stated).
3. Convert all offers to the same basis (usually EAR) using EAR = (1 + APR/m)^m − 1.
4. For installment loans, compute the monthly payment with PMT = r × PV / [1 − (1 + r)^−N], where r is the periodic (monthly) rate consistent with how payments are applied.
5. Include fees: convert up‑front fees into an annualized cost or add to PV before computing payments when comparing true cost.
6. Consider other terms (prepayment penalties, adjustable rates, collateral requirements).
Worked numeric comparison (two loan offers)
– Scenario: You’re comparing two nominal APR offers for the same loan principal; choose the one with the lower EAR.
Offer A: APR = 12.00%, compounded monthly (m = 12).
EAR_A = (1 + 0.12/12)^12 − 1 = 1.01^12 − 1 ≈ 12.6825%.
Offer B: APR = 12.20%, compounded quarterly (m = 4).
EAR_B = (1 + 0.122/4)^4