What is loan affordability?
What is loan affordability? Here is a little background. A consumer may find themselves needing to take out a loan for many reasons. A lot of consumers use them to combine existing debts. Other reasons might include the need to buy an expensive product.
For example, a vehicle or household appliance. Another reason why consumers take out loans is to cover an unexpected financial expense. Whatever the circumstance, the key thing to consider is whether the product is affordable.
Typical borrowing rates will vary between lenders. They will also reflect the consumer’s individual credit history score. If a consumer has a poor or adverse credit history this will be noted.
Consumers with a County Court Judgment may get refused credit by high street banks.
This means they will have no option but to rely on subprime lenders. If this becomes necessary then they can expect much higher interest rates.
They may also get offered much less favourable terms than those offered on the high street. In these cases, the bank has to consider the potential risk of failure to pay. This might also include the consumer absconding or entering into bankruptcy.
Suffice it to say, if a consumer feels that they cannot meet repayments they should not take out a loan. This decision can include many factors, for example being in temporary or seasonal work. If there is any possibility of not being able to meet repayments then entering into a loan is not advisable.
Failure to meet loan repayments will appear on a credit history score. This can also make it difficult to apply for credit in future.
These are also known as ‘non-prime’, ‘near-prime’ or ‘second chance’ lenders. They provide loans to consumers who have been unable to lend from their high street bank. They might also provide mortgage services too.
This decision will depend on the consumer’s credit score and affordability score. These scores are available from credit reference agencies. Some of the most favoured agencies include Experian, Equifax, and CallCredit.
All three credit reference agencies have products tailored to help with assessing loan affordability. Some of these products provide solutions which are also widely used in the sub-prime credit industry.
Credit scores and affordability
A person’s credit score is a measure of how likely they are to repay and meet their credit commitments. Credit score data is used in underwriting, much like affordability. In fact, affordability analysis and credit scoring complement each other to give a complete picture of the borrower’s circumstances.
Individual scores will reflect various factors such as missed repayments on previous loans. They will also include unsatisfied overdraft agreements and Court proceedings. If a person has a County Court Judgment registered against them this will be on the score. The record will also show how many applications for credit are evident.
A score will also show the lender whether there is an entry on the electoral roll. This can be important for various reasons. For the lender, it shows a steady history of residential occupancy.
This generally means that the intended lender is less likely to move address. This can be a good indicator for the lender since it means he or she is less likely to abscond.
A credit score will also show any “known associations”. These include a business partner or spouse. This is why it is important to ensure information is always up-to-date. This is particularly true for anyone wishing to apply for credit in the future.
Certain information, such as County Court Judgments, will remain on record for six years. They will continue to show even once paid. If you wish to see a copy of your credit report you can do so by paying a minimal fee of £2.00. Further details on how to do this are available online. Requests for this information will usually be in writing.
Some consumers struggle to get offered credit. This can sometimes be due to them having no credit history. If a person has no history it is difficult for a lender to tell whether they might default. As such, in these cases, the lender will tend to assume the worse case scenario.
A lender might then ask for proof of ability to pay before offering a more favourable interest rate. This may take some time to achieve. That said, once done, future lending will tend to be at a preferable rate.
The same scenario can also apply to non-property owners. This is because the banks are unable to secure their interest. Should the consumer fail to pay then they would be unable to ‘enforce’ against the property. This is otherwise known as a ‘Charging Order’. If a lender is able to offer a secured loan, then the rate tends to be more preferable.
Underwriting affordable loans
When considering any loan application each lender will consider the affordability at great length. They will also apply their own lending policies and procedures to reach a decision. Lending strategies will vary from bank to bank.
The same is true for sub-prime lenders. Some banks might multiply the consumer’s income by a certain amount. For example, a £20,000.00 income x 3 = £60,000.00.
Some financial institutions might also offer a secured loan on a ‘loan to income ratio’. This might be, for example, 27% of the consumer’s monthly income. A potential lender might also consider the amount of debt the consumer already has.
If they do not do this, then the consumer should since it reflects on their ability to repay. This is referred to as ‘debt to income’ ratio. This can be a much more sensible method of borrowing. It ensures that the consumers do not over commit to repayments across different lenders.
Unfortunately, it can be tempting to accept a loan agreement without thinking first. If a consumer has many debts across different lenders this can lead to early defaults.
Affordability is a key factor in sub-prime lending. Following tighter regulation in recent years and a lot of scrutiny from the FCA, most lenders will now look at affordability as the determining factor when lending. A lender must nowadays be able to provide evidence for having conducted a thorough affordability assessment.
To ensure a consumer gets the correct product a good lender will consider many things. This will most likely include a loan affordability calculation. This will look in depth at all income and outgoings. It will also consider any priority debts (such as secured loans against a property).
A lender will also consider any other income the consumer might have. This could include any tax credits or even a second income. Remember, this calculation will also include any general living costs. Living costs can include transport, child care fees, meals and so on. The remaining balance after deductions will be a consumer’s ‘disposable income’. In other words, the amount they can afford to put towards something else, such as a loan.
Consumers can calculate their own disposable income with ease.
When considering affordability it is also important to ask your lender as much as possible. For example, how much you will have to pay each month, what the interest rate is and how much you will pay back.
It is also advisable to ask whether adjustments can take place. Consumers should also ask whether any penalties are likely. These can even occur in the event of early repayment. It might sound obvious but the less a consumer borrows, the better. The same is true of actual repayment periods.
Suffice it to say that no decision to lend is easy but the key is to ensure both affordability and suitability.