When you apply for a loan, the bank or lender looks at two main factors:
- Your credit and credit score.
- Affordability, can you afford to repay the loan.
When you apply for a loan and a lender looks at your credit report and credit score, it is a done deal. Your credit score is what it is, however, affordability is another issue, and not just a done deal.
Why you may ask?
You state to the lender what your income is, either online or via the phone, and you also tell them your expenses. In some instances, the lender just takes your word for it; what you say is what they go by to determine affordability.
Yes, a lender can request documents to prove your income/wages, and your expenses. However, many lenders do not request proof.
Again, why you may ask?
Competition to other lenders, and also to get loans approved. The more loans approved, the more money a bank or lender can make.
Has this process for lenders been a good one? No, more and more lenders are in the news for poor affordability practices, and also more and more are going into Administration, in part due to having to pay claims to borrowers, who could not afford to repay their loans.
There was no due diligence to insure they could afford to repay the loan.
So how does a lender determine affordability for a loan?
For some it is ratios, the ratio of how much debt the borrower has to income, and also the ratio of how much income to monthly expenses.
And you ask, what are these ratios????
They can vary from bank-to-bank, lender-to-lender.
Years ago a 30% to 35% debt ratio was considered high. And a total expense for living costs to income were 40%-45%. Lenders wanted a buffer. Today, things have changed.
An example may be a borrower has an after tax wage of £1,500, and his normal monthly bills, rent/mortgage, utilities, food, etc add up to £1,000. This is a ratio of just over 66%. If you add in one loan payment of £150 a month, that ration rises to over 76%.
If a borrower has no debt, but takes out a loan of £200 a month, and has £800 a month in expenses, and the same £1,500 income, the debt to income ratio is just over 13%, which is low, and the total expense ration is again 66%.
It is all about affordability, which it appears many lenders have not done the maths.
Regulation of Loans….The FCA
The FCA is the Financial Conduct Authority, which replaced the Office of Fair Trading back in 2014.
All things credit must be approved and regulated via the FCA. They have strict compliance rules, and govern all things banking and credit.
Even with this “strict” regulation, some lenders do not do the tests that should be done to insure affordability. This is why many lenders go into Administration, and go bust due to complaints, and redress from borrowers.