By Carla Fried | American Express Credit Intel Freelance Contributor
5 Min Read | July 31, 2020 in Money
Lending standards generally get tougher during an economic downturn.
When lenders aren’t itching to make loans or offer new credit cards, a higher credit score may increase your chances of getting approved.
One personal debt statistic to push lower in a downturn is your debt-to-income ratio (DTI).
If you’re angling to borrow money when the economy is going through a rough patch, be prepared to face higher hurdles than in boom times. Lenders usually use more stringent loan requirements when the economy stops humming. They tighten credit qualifying rules in an effort to up the odds that they will only make deals with borrowers who will be able to repay the loan, on time. In that environment, personal debt management requires knowing how to navigate the changing debt landscape.
Consider how the personal debt landscape changed rapidly during the Great Recession. Back in 2007, the year before the Great Recession kicked in, a monthly Federal Reserve survey of banks found that tight consumer lending standards were rare. Flash forward to October 2008, the darkest days of that recession, and around 70% of bank lending officers in the same survey said they were tightening their rules for consumer loans.1
But that doesn’t mean that in a rough economic stretch it is impossible to get a loan or a credit card. Just harder. Which isn’t surprising, right? When unemployment is rising and businesses aren’t making as much money, it makes sense that financial institutions are cautious when making loans to households, which, on average, already carry thousands of dollars in debt (see: Average U.S. Credit Card Debt). Total consumer debt in 2019 was more than $14 trillion.2
When seeking approval for a personal loan or line of credit, it’s useful to understand how the qualifying rules might become more stringent during a downturn.
Preparing to shine. You may be eager to borrow, but it’s important to understand the lender’s perspective: their interest in offering personal debt decreases during a downturn because the risk has increased. Back in the fall of 2008, that monthly Federal Reserve survey of bank loan officers cited above found that nearly 50% of the bank officers surveyed were less willing to extend any kind of personal debt – mortgages, auto loans, personal loans. Since then, lending standards have risen.
Responding to rising credit score requirements. The average credit score required to land a loan typically rises when the economy is faltering. Same goes for getting a new credit card. Even if you can’t yet boost your credit score into the excellent range (see: Credit Score Ranges: What is an Excellent, Good, or Poor Credit Score?), taking steps to raise your credit score even a few points is especially smart when you want to borrow during an economic slump (see: 7 Best Ways to Help Build Your Credit). In 2007, the average FICO credit score for used car financing was about 660. But by late 2009 – during the recession – it rose to 684. For new car loans the average rose from 749 to 775.3
Bracing for higher down payment requirements. To reduce their risk, lenders may become less willing to accept low down payments for loans. A lender that is willing to give you a mortgage with a 3% down payment in good times might require a 20% down payment when the economy is struggling. That said, lenders will often look at the big picture. For instance, if you have an excellent credit score and a steady job, you may be able to obtain a mortgage with a slightly lower down payment.
Tougher debt-to-income ratio requirements. When you apply for any type of loan, a lender will compute your debt-to-income ratio (DTI): the percentage of your gross monthly income that you use to pay off loans, including the one you are applying for. When the economy is doing well, you may be able to land a loan with a DTI of 40% or even more. But keep in mind that lenders prefer a DTI of 36% or less. That’s a smart target to aim for in a rougher economic climate. If you have any debts that you are near to having paid off – say a credit card balance, or a student loan – you might want to spend a few months eliminating that debt before applying for a new loan. For more, read “How to Get Out of Debt in 2020.”
Increasing interest rate volatility. Recent history suggests that it’s even more important during a downturn to be diligent and thorough when shopping for credit. In early 2020, for example, mortgage interest rates became very volatile, sometimes ranging between 3% and just over 4% within the same week. In such an unpredictable financial climate, being both patient and prepared can help you secure the most favorable lending terms.
Getting approved for a loan or a new credit card during an economic downturn requires meeting tighter (read: tougher) rules. To increase your chances of obtaining a needed loan, take the time to develop a personal debt strategy that is fine-tuned to address common lender concerns during difficult economic times.
2 "Household Debt and Credit," Federal Reserve Bank of New York
3 "Automotive Financing Report 3rd Quarter 2009," Experian