Loan affordability is a measure of a potential borrower’s ability to pay back their loan in full and on time. Each lender uses their own formula to calculate it. Fundamentally, however, loan affordability is always based on a lender’s interpretation of a potential borrower’s income and expenses/obligations. Keep reading to learn more.
What is loan affordability and why is it important?
Loan affordability is a measure of a potential borrower’s ability to repay a loan without compromising other financial obligations. It’s important because it protects both the borrower and the lender from the consequences of default.
Lenders need to ensure that they act responsibly when approving an application for a loan. Completing a loan affordability assessment enables them to make sensible and responsible decisions to ensure that customers can afford their loans and that they will not suffer detriment by taking out the loan.
How is loan affordability calculated?
In the UK, lenders must calculate loan affordability in accordance with the guidance set out by the Financial Conduct Authority (FCA). The main criteria it highlights are:
- Income and expenses
- Credit score
- Debt-to-income ratio
Lenders can apply their own formula to how they assess these. The FCA does, however, recommend that borrowers should have a maximum debt-to-income ratio of 43%.
Lenders are also permitted to make reasonable assumptions about a borrower’s future prospects. They must, however, base these on data and be careful to avoid unjustified optimism.
At the end of the day, all lenders must be able to demonstrate that they had reasonable grounds to believe that a loan was affordable to a borrower before they issued it. They must also be prepared to show and, if necessary, defend the process by which they came to that conclusion.
Some lenders provide loan affordability calculators. These help potential borrowers check whether an application would be accepted. For example, you can check out this homeowner loan calculator.
Factors that affect loan affordability
As previously mentioned, the three main factors that affect loan affordability are:
- Income and expenses
- Credit score
- Debt-to-income ratio
Lenders may also check a potential borrower’s employment status and the availability of assets/guarantors.
Here is some more detail about how lenders use this information.
Income and expenses
Your income and expenses give lenders a benchmark of your disposable income. This enables a lender to see how much money you have each month to make the repayments on your loan.
Credit score and report
Just like with loan affordability, there are various factors that influence your credit score. Additionally, each credit agency has its own formula for calculating credit scores.
With that said, the main factor that affects your credit score is your payment history. A long history of responsible credit use means a higher credit score. Other important factors include your level of credit utilisation and the types of credit you use.
Knowing a potential borrower’s credit score and history enables lenders to assess how well they can manage credit.
Your debt-to-income ratio indicates the proportion of your income that goes toward servicing your existing debt. According to FCA guidelines, borrowers should have a debt-to-income ratio of, at most, 43%.
Knowing your employment status enables lenders to make a reasonable judgement about your income over the term of the loan.
Some types of loans are only available to people with assets they can offer as security (e.g. mortgages). Other types of loans may not specifically require you to have assets. Lenders may, however, look more favourably on applicants who have them. Applicants who do not have assets may, however, still qualify for credit if they can offer a guarantor.
It’s important to understand that loan affordability is very much dependent on the terms of the loan. For example, the same lender might judge the same person as being unable to afford a short-term, high-interest loan but able to afford a longer-term, lower-interest loan.
How to improve your loan affordability
Improving your loan affordability tends to be a long-term process. Ideally, therefore, you should keep it in mind whenever you make any financial decisions. Here are three key points to consider.
Take care of your credit score
Effectively, the only way to build and maintain a credit score is to keep paying all your bills, in full, on or before their due date.
If you have a mortgage, you have a straightforward path to building a credit score. If you are renting, you can ask your landlord if they can report your rent payments to the credit agencies. If they don’t or can’t, you may be able to report your rent payments yourself.
Additionally, think carefully before you take on any credit. Remember it will influence both your disposable income and your debt-to-income ratio. It will also affect the mix of credit on your record.
Manage your debt-to-income ratio
There are basically two ways you can manage your debt-to-income ratio. One is to increase your income and the other is to the amount of income that goes towards your debts. Ideally, you’ll do both.
Keep in mind that you may be able to reduce your debt-to-income ratio even if you can’t afford to make additional debt repayments. You could do this by moving the debts onto more affordable products.
Consider what credit you apply for
There are two parts to this. Firstly, keep in mind that the mix of types of credit you use will influence your credit score.
Secondly, remember that lower-interest loans will always be considered more affordable than higher-interest loans. In the real world, however, the end cost may be the same (or higher).
For example, a loan with a lower interest rate but a longer term may end up costing the same (or more) as a loan with a higher interest rate but a shorter term.
Tips for borrowing responsibly within your loan affordability range
Here are three top tips for borrowing responsibly within your loan affordability range.
- Always borrow mindfully, especially if you are borrowing for a want rather than a need. Think through all your options before deciding whether or not to commit.
- Always do thorough research before you borrow. Make sure that you understand the full terms of any loan, not just the headline interest rate.
- Always leave yourself with room to manoeuvre. In particular, think about how you would make repayments if something unexpected happened. For example, could you cover them with cash savings or insurance?
If you’d like to apply for a homeowner loan, contact one of our trusted broker partners for more information.