Affordability checks are a must before a loan application approbation. You hear it a lot, regardless of the loan you apply for. While taking out a personal or secured loan, you need to carefully assess your affordability, which, in other words, is your repayment ability. A low interest rate does not make a loan affordable. An affordable loan is one which you can settle on time without struggling to pay for your essentials, such as rent, groceries, commute expenses, and unexpected expenses, such as a car repair or an unexpected medical bill.
Lenders scrutinise your current financial condition to understand your repayment ability despite potential setbacks such as unemployment. They calculate an affordability score, which is clearly different from a credit score.
What is an affordability credit score?
An affordability score represents your affordability. The score is calculated based on the number of factors, such as:
- Total amount of cash coming in
- Your regular payments, such as rent, utility bills, commute expenses, etc.
- Any contractual payments, such as mortgages, loans, etc.
- An ideal size of an emergency cushion to pay for unexpected expenses
Now you must have some money left at hand after paying for all your essential expenses. Is that money enough to repay a £1,000 loan with bad credit? Will you still be comfortable keeping up with payments if any small emergencies crop up?
How lenders assess your affordability
A responsible lender would have to run an affordability check in order to ensure you do not fall behind in payments. Here is how your affordability is assessed:
Your income
First, they evaluate your income. How much money comes in every month in total? They will determine the total amount of cash coming in by clubbing all your income sources. In fact, dividends and interest from investments also play a vital role.
You must be able to earn enough money to pay for all your essential expenses. For instance, if you decide to get a 3,000-pound loan with bad credit from a direct lender in the UK, they will certainly ensure that your income is stable and you will not struggle to pay for essentials because of the debt payment.
A debt-to-income ratio
Another important thing that they look at is how much debt you owe against your income. A high debt-to-income ratio suggests you often rely on debt to meet your expenses. Taking on additional debt will undoubtedly increase the burden on your finances.
A lender would certainly reject your application if they find that you will not be able to repay the debt on time.
The size of the deposit
If you are looking to take out a secured loan, you will need to put down collateral. The higher the deposit, the lower the loan amount will be. Of course, it will reduce the cost. Even if your credit score is not perfect, you might be able to qualify for competitive interest rates. A larger deposit is recommended, especially when you have other obligations to pay as well.
How is an affordability score different from a credit score?
An affordability score is different from your credit score. The former includes taking stock of your incomings and outgoings to assess your repayment capacity. Every lender uses their own formula to calculate your affordability score. It is not necessary that they would give it a two or three-digit number. You can afford to pay off the debt as long as you can make monthly payments without struggling with other expenses.
A credit score, on the other hand, is a three-digit score that credit reference agencies – Experian, Equifax and TransUnion – calculate based on your borrowing history. The score suggests whether or not you were a responsible payer in the past. It cannot determine your current repayment capacity.
When lenders lend money, they check both past payment behaviour and current financial position. Your credit score should also be high to obtain lower interest rates.
How to prove your affordability?
Even though your credit score is stellar, you cannot get a loan signed off on if you fail to prove your repayment capacity. Whether you are a full-time employee, freelancer or self-employed, you must demonstrate your repayment capacity. Here is how you can demonstrate your repaying potential:
- Try to increase your income. Increased cash on hand will help you ease with payments. This is what lenders would particularly want to look at.
- You should try to minimise your expenses. By cutting back on discretionary or inessential expenses, you will be able to retain some cash at hand.
- Try to stay within your budget. This will ensure better management of expenses.
- Make sure that your accounts are updated. Whether it is a short-term debt or an energy bill, you should pay them off on time. On-time obligations demonstrate responsible behaviour.
- Ensure that you have enough savings to pay for unexpected expenses. Ideally, it should be at least three months’ worth of living expenses.
What if you fail an affordability check?
Every lender will run an affordability check before approving a loan application. If you fail to prove your affordability, you will be refused a loan. Some lenders may offer you less than what you intended to borrow, but that is not always feasible.
Most people fail to pass an affordability check as they already owe too much debt. Therefore, it is advisable that you take stock of your current financial condition. You should carefully estimate if you can actually repay the debt along with other essential expenses.
Try to speak to a financial advisor if you have any doubts. If you failed the affordability check, it is enjoined to ask for a reason.
The final word
Your credit score is important, but at the same time, your affordability is also vital. No lender would be able to sign off on a loan if you cannot afford it. A subprime credit rating can still let you secure a loan, but a lack of affordability will result in a straightaway rejection.
