What’s a high-risk borrower? One whom lenders and banks view as being more likely to miss payments or default on loans. Because these borrowers pose a greater financial risk, lenders and financial institutions charge them higher interest rates as a type of safety net.
So, it's safe to say you don’t want to be considered a high-risk borrower. Fortunately, you can avoid this label by not making certain financial mistakes.
Here’s a look at the money missteps most likely to get you pegged as a risky borrower.
1. A Weak FICO Score
Having a low FICO credit score -- especially one under 620 -- will certainly earn you a label as a high-risk borrower, said David Bakke, a personal finance expert at the Money Crashers blog. A low credit score tells lenders that you've had trouble making payments on time in the past or that you've run up too much credit card debt.
A low score makes lenders hesitant to approve you for new loans or credit cards. And if they do? They'll stick you with high interest rates to mitigate the risk of lending to you.
Bakke recommends that you pay your bills on time, the top way to keep your credit score high. Your mortgage lender, auto lender, credit card provider and provider of your student loan will all report payments that are late by 30 days or more to the three credit bureaus of Experian, Equifax and TransUnion. These late payments will cause your credit score to drop by as much as 100 points. That's why paying these monthly bills on time is so important, Bakke said.
Bakke also recommends that you pay down your credit card debt, as high levels of debt can also lower your credit score. And don't close credit cards when you are no longer using them. Taking away the credit that is available to you can also hurt your score.
2. Missing Payments
Jacob Dayan, chief executive officer and co-founder of Chicago-based accounting and tax services company FinancePal, said that paying mortgage, credit card or auto loan payments late — or failing to pay them at all — could tag you as a risky borrower.
That’s because lenders and credit card providers worry that if you’ve missed payments in the past, you could do it again. This makes you a higher risk in their eyes, Dayan said.
Missed payments don't just disappear, either. They remain on your three credit reports for seven years. If you don't want to be viewed as a high-risk borrower and get higher interest rates, pay those bills on time.
3. Bankruptcies, Foreclosures, Collections
Filing for bankruptcy or losing a home to foreclosure will cause your credit score to spiral down, by 100 points or more. Bankruptcies will remain on your credit reports for 10 or seven years, depending on the type you file, while foreclosures will remain on them for seven years, too. These negative financial judgments will certainly tag you as a high-risk borrower, and lenders will be hesitant to do business with you.
Another strike? If you miss too many payments, your creditors might send collection agencies after you. When your accounts go into collections, this, too, shows up on your credit reports and makes you appear to be a high-risk borrower in the eyes of lenders and banks.
4. Lots of Debt
Too much debt can tag you as a high-risk borrower, too, said Jordan Tarver, financial analyst at New York City-based FitSmallBusiness.com.
Again, it comes down to the risk that lenders take on. If you already have mounds of credit card debt and several loans that you are paying off each month, lenders will be leery of providing you with more debt. The fear is that you'll become overwhelmed and struggle to pay back their loan.
That's why lenders look carefully at your debt-to-income ratio when deciding whether to approve you for a loan. This ratio looks at how much of your gross monthly income -- your income before taxes are taken out -- is consumed by your monthly debts, everything from your mortgage payments to your required minimum credit card payments.
Most mortgage lenders want your monthly debts, including your estimated new mortgage payment, to take up no more than 43% of your gross monthly income. But Tarver said that any debt-to-income ratio above 40% can tag you as a high-risk borrower.
Fortunately, you can lower this ratio. "By paying off existing debt or finding ways to increase your income, you can lower your debt-to-income ratio and appear as a low-risk borrower to lenders and banks," Tarver said.
Bottom Line
The same general principles that will keep your credit score high are ones you'll want to practice if you're looking to avoid high interest rates on your credit cards and any loans. If you're using your credit cards responsibly and remembering to make all payments in full and on time, you should be well on your way to improving your financial standing.
