3 Ways to Ensure 'Loan Grading' Works in Your Favor

Loan grading determines the terms and rates of our loans.

Any time we apply for a loan, lenders assign a grade. It may not seem obvious because loan grading goes on behind the scenes, but it plays a massive role in whether our loan application is approved and the interest rate we're offered. Here, we'll outline how loan grading works and what you can do to ensure it works in your favor. 

What is loan grading?

When you apply for a loan, lenders grade your application. It's their way of evaluating how likely you are to repay the loan. The practice is also referred to as "loan scoring." The tricky thing about loan grading is that each lender has a different system for determining your creditworthiness. Further, they each use various labels for grades. 

For example, when some peer-to-peer (P2P) lending platforms evaluate a loan application, it's assigned a letter grade from A to G. A Grade A loan is considered low-risk, and a Grade G loan is high-risk. 

A borrower with a loan rated Grade A can expect to pay a far lower interest rate than a Grade G borrower because the lender sees the Grade A borrower as a low-risk loan. 

The point is this: The best way to land a loan when you need it and pay the lowest interest rate possible for that loan is to make sure loan grading works in your favor. Here's how you do it:

1. Examine your credit score

Before applying for a loan of any kind, order a copy of your credit report from the three major credit reporting agencies -- Transunion, Equifax, and Experian. You can order all three reports at one time from a site like AnnualCreditReport.com. By law, you're allowed one free copy of your report from each agency once a year.

Look each report over to ensure there aren't any mistakes. Even minor errors can drop your credit score. Credit reports do not show your FICO score (the score most lenders use to determine how well you've managed debt in the past), so you'll need to find that score elsewhere.

You can pay for it through MyFico.com. Alternatively, most credit card companies provide credit scores for free to their cardholders. 

Credit scores range from 300 to 850. The higher your score, the better your financial reputation, and the more likely lenders are to approve your loan. 

If your credit score is low, you'll be ahead if you take the time to give it a boost. A strong credit score makes it easier to get a loan, but it can also help when it's time to rent an apartment or get a job. 

Once you have your credit score where you want it, make it a point to check it a couple of times each year, just to make sure nothing has changed. The first -- and best -- way to ensure a high grade from lenders is to present a high credit score. 

Bottom line: Focus on your credit score

2. Keep loan-to-value ratios low

A loan-to-value (LTV) ratio expresses how much you owe on something compared to its worth. Let's say you purchase a home for $200,000, and once you put 20% ($40,000) down, you owe $160,000. If the value of the home is $200,000, that means you have an LTV of 80% (because $160,000 is 80% of $200,000). 

Now, let's say you want to borrow money to purchase a car costing $35,000. If you have no trade-in and no money to put down on the vehicle, you'll need to borrow the entire $35,000. A LTV of 100% makes the loan riskier for lenders and may impact how they grade your loan application. 

To ensure a better grade, keep the LTV down by making a larger down payment. For example, if you save up $10,000 to put down on the car, you'll need to borrow $25,000. That leaves you with an LTV of approximately 71%, and the loan is more attractive to lenders.

A low LTV represents two things to a lender, and both factor into the way your loan is graded:

The more you put down, the more "skin you have in the game." The more of your money goes into a purchase, the more likely you are to keep up with payments because you don't want to lose the money you've already invested. 

The lower the LTV, the easier it will be for a lender to recoup its loss if you stop making payments. Let's say you buy that $35,000 with no money down. If you miss payments and the lender must repossess the vehicle, chances are, it will not be able to recoup what you owe. That's because a car is worth less than you paid for it the moment you drive it off the lot.

However, if you make a sizable down payment and keep the LTV low, the lender can repossess the car and potentially sell it for more than is owed. 

Bottom line: Put your own money on the line. It makes you more attractive to lenders. 

3. Provide collateral when necessary

Let's imagine you want a personal loan to remodel your kitchen. Most personal loans do not involve collateral, but you want the highest loan grade possible to keep your interest rate low, so you look for a lender that accepts collateral. Here's how it works:

• You apply for the loan, offering a piece of land you inherited (or any other item of value that can be appraised) as collateral.
• Your credit score is not perfect, but the lender knows there's no way to lose its entire investment if it grants your loan. That's because if you fail to make payments, the lender can take possession of your collateral, sell it, and recoup its money. While it's not entirely risk-free for the lender, it's considerably less risky than lending you money without collateral as a backup. 
• Your loan is approved and you determine whether the interest rate offered works for you. 

Bottom line: Unless you have excellent credit, you're likely to receive a higher loan grade if you provide collateral. 

Loan grading is a lender's way of predicting how likely it is to be repaid in full. The higher your grade, the better the terms of the loan. And the better the interest rate and terms of your loan, the more money you can keep in the bank.