3 Steps To Follow To Make Sure You Can Afford a Loan
- 8th March 2018
- Posted by: Loanable
- Category: Resources
Applying for a loan these days can be confusing, daunting, and even a bit scary.
Things have changed in the banking and lending industry over the years, and as consumers and borrowers, we may not always be “in the know” as to what these changes are, and how these changes may affect us if we wish to apply for a loan.
A few years back there was a “credit crunch” in the banking/lending world, which affected many individuals and businesses who were seeking out loans and funding to either make purchases, or continue operating as a business.
If you were unaware of this change or credit crunch, you could be in for a real surprise when you went to apply for a loan, thinking all is well and you will be approved, only to be rejected for the loan.
Loan application, denied!
It is not a good feeling having a loan rejected, especially when you may need the loan. Perhaps you were looking to finance a car, do upgrades or refurbishments to your home, or worse yet, be rejected for a mortgage to purchase your first home.
For someone who may not work in banking, or keep their noses in the financial trade journals and read the financial news each day, it can be a lot to take in as to the changes in lending and banking, and also in the world of finance as a whole.
Well, we are here to make things easy for you. We are going to synthesise it all down for you to insure you can afford a loan.
In applying for a loan there can be many factors involved:
- Purpose for the Loan
- Borrower’s Stability
If you look at these factors involved in being approved for a loan, the top two are credit and affordability.
However, even those with weak, poor, or no credit can get approved for a loan, as there are bad credit loans available to them.
Some of these loans do not even involve a credit check, so credit is not an issue. But affordability for a loan is an issue!
There are loans available to people with poor or bad credit, but all borrowers need to show affordability; they need to show they can afford the loan.
You can have the strongest credit in the world, and you may get approved for a loan, but if you cannot afford the loan, or will struggle with the payments, then the loan does no good for you or the lender.
Granting loans to those borrowers than cannot afford them is costly to lenders. They lose money, either in the form of defaults, or the costs associated with trying to collect the loan.
From some standpoints, affordability is more important than credit or the other factors that go into underwriting a loan application.
To break it down into simple terms as to what one can do to insure or guarantee they can afford a loan, it can be looked at as three (3) components:
- Preparation: Preparing for making an application for a loan.
- Execution: Executing the process, making an application, and understanding the various terms, and questions that may be asked when applying for a loan.
- Sustainability: And I am not speaking here of fishing Cod in the Northern Sea, but not just showing affordability, and being able to afford a loan, but having a plan in place to maintain that affordability. Some loans are for years, and you need to be aware of this, and being able to afford the payments for that time period.
These three (3) factors always need to be looked at in the context of affordability.
We will delve into each of these in more detail as we march/read on.
However, before we do, march on, do a little experiment for me…indulge me for one moment. You’ll understand why in a short time, and try to be as honest as you can.
Without looking, no cheating, how much money do you have on your person at the moment?
Now count the money you have and see how accurate you were, to the penny.
Some people will be spot on as they said “I have no money” and indeed they have none.
To the penny and pound, how much do you bring home in wages and other income each month?
Then, how much to the penny and pound how much are your monthly expenses and bills?
I would be surprised if anyone, including myself, could be 100% accurate with this one.
If you earn a salary that never changes month-to-month, then you may know your earnings, but monthly bills can fluctuate, such as money spent on food, various holidays that come up during the year, gift giving, etc.
To be able to feel 100% confident in affording a loan, you need the answers to these questions. If you do not know the answers prior to applying for a loan, the lender may know the answers before you do, and it could affect your receiving the loan or not.
So onward and upward we go, to not just improve your chances of affording a loan, but making sure before you apply for a loan, you know, I can afford it, and so will the lender.
Chapter One: Preparation
There are many quotes or idioms about preparation, one being, “By failing to prepare, you are preparing to fail”.
And this can be true of applying for a loan.
If you do not know what may be asked of you on a loan application, or the process of applying for a loan, let alone the jargon and terms used for lending, and being able to show/prove you can afford the loan, you may be setting yourself up for failure in the form of the loan being rejected.
What we are going to look at in this chapter is all the preparations you need to do to insure your loan is approved, especially in showing that you can afford the loan.
The things we will look at and touch on are the following:
Eligibility: Qualifying for a loan, on the surface.
Credit Score and Credit History: Important, but secondary to affordability.
Needs: Why do you want or need a loan?
Terms and Tricks: Lending ratios, APR, and other loan terminology such as repayment term, and ways to reduce monthly payments.
Affordability: The all important showing you can afford to repay a loan. Doing your own income and expenditure sheet, making “phantom payments”, and paying oneself.
Guaranteed Ways to Get a Loan: There are ways to show you are an excellent candidate and borrower for a loan.
As you may guess and see, the preparation process may take some time. It is not meant to be a “quick fix” to getting a loan, but winning the war, and not just the battle.
This list of what we will discuss here is not meant to be in any particular order, however, for some people it may be easier if they do follow an order to things, and one starting point is to ask oneself:
Why do I need a loan?
What is the loan for?
Not only is this a good starting point, but you can expect a lender to ask the very same question. If they are going to give/lend you money, they have a right to know what that money is to be used for.
For some people the answer(s) to these questions are very easy; they wish to finance a car, purchase a property, or do repairs or refurbishments to their home.
For others they may need to rethink why they need a loan.
Is the loan to consolidate other debts, for a holiday, or for something not necessarily needed.
These types of loans may be looked at and reviewed more closely by a lender, and this is where showing affordability can be a crucial factor.
Especially consolidation loans.
If you are consolidating 3 or 4 or more debts into one monthly payment, in many instances that monthly payment may be lower than what you are currently paying each month for the accounts separately.
Even with the reduced monthly payment, you want to show you can afford the payment, and why it is beneficial to you.
Before applying for a loan you need to be aware that when you do apply for a loan, a footprint or inquiry is placed on your credit history. Too many of these footprints in a short period of time can reduce your credit score.
However, checking your own credit does not affect your credit score.
There are various eligibility checkers out there that will tell you if you may be approved for a loan. And these are good to use when considering a loan, as it can give you an indication as to if you may be approved for a loan or not.
However, eligibility checkers do not look at affordability, so finding out you are eligible for a loan and receiving a high probability that you may be approved, does not show or mean you can afford the loan. Once the application is fully reviewed and underwritten, you may have an affordability issue which could hinder you receiving the loan.
Credit scoring and its use in making loans is being used more and more these days. And while credit history and credit scores are a good indicator of who will and who may not repay a loan, they do little to show affordability.
Someone may have had credit issues in the past, but can clearly show they can easily afford to repay a loan now, and due to a low credit score, may be passed over for a loan.
Only one aspect of credit scoring may even come close to showing affordability and that is outstanding balances you may now have on accounts.
The amounts owed that make up a credit score is 30% of someone’s score, which is a high percentage, and the second highest percentage used for making up credit scores.
This leads to lenders looking at ratios, more of which we will cover and explain when we discuss Terms and Tricks.
Why Do You Need a Loan/What is The Loan For?
As previously mentioned, this is usually a starting point, or the beginning of when a person decides they need a loan.
This can also dictate what type of loan a person may require.
There are different loan, for different needs.
If someone wants to buy a property, they will need a mortgage; unless they have saved up the money to just pay cash. Which would be rare.
If you want to buy a car, you may require a special car loan, if you want a revolving line of credit, then perhaps an overdraft or credit card.
Your borrowing needs will dictate the type of loan you need, and lenders will ask you in most instances, what the loan is for.
Terms and Tricks
Unless you are in banking, or some other aspect of the finance and lending industry, you may not be aware of some of the terminology used, or some of the finer points used in assessing an application for a loan.
Here we need to look at understand:
APR/Annual Percentage Rate: One of the most important aspects of a loan is the interest rate. This is the money you will pay for receiving the loan, and it is expressed for many loans as an APR or Annual Percentage Rate.
The APR is the interest rate for a loan, but annualised over a full 12 months or year. For some short-term loans, such as payday loans, which are meant to be paid back quickly, within 30 days, it causes the APR to seem quite high, like 1000% or even higher.
The higher the interest rate, the more the loan costs you, the lower the interest rate, the less a loan costs you in what you pay in interest.
So in essence a higher interest rate, or APR, can make a loan unaffordable as it can cause the monthly payment to be higher.
So we need to be aware of this when looking for a loan.
Income to Debt Ratio and Payment to Income Ration:: For some loans, when a lender looks at the borrower and underwrites the loan, they may look at two very important ratios. These ratios are the borrowers income to total debt, and the borrowers income to the loan’s monthly payment ratio.
This can be confusing, but it plays a huge role in affordability of a loan, and something as an informed borrower, we need to know and understand.
An example would be this:
You want a loan for £10,000, and you currently have 3 outstanding accounts, a credit card, a car loan, and a mortgage.
A breakdown of these loans is as follows:
- Your monthly mortgage payment is £500
- The minimum monthly payment on your credit card is £60, on a £2,000 balance
- Your car note is £200 a month
So not counting bills, your monthly debt payments are £760.
Your gross monthly wages, before taxes and NI deductions is £2,500, which makes your debt to income ratio 30%. £760 divided by £2,500 = .30.
Now let’s look at this in a different manner, say your total monthly debt payments are still £760, however your net income after taxes and NI is £1,875, this makes your debt to income ratio 41%.
Many lenders use gross income, however, some may look at net after tax income as well.
The payment to income ratio is the monthly payment of the new loan, divided by your monthly income. So a new loan which carries a monthly payment of $200, would have a ratio of 8% based on gross wages, and 11% based on after tax income.
The lender also has to look at what these rations will be with the new loan payment.
So by adding this new £200 a month payment into the mix, someone with a total debt to income ratio of 30%, now has a ratio of 38%. £760 + £200 = £960 divided by $2,500 = 38%.
As to what ratio amounts or figures a lender may use can vary according to other factors.
If a borrower has a strong credit score, a lender may allow the ratios to exceed their top end. As to what the exact ratios a lender may use are, can vary from lender-to-lender.
Confusing I know. But if you are aware of these ratios, and work out your numbers prior to applying for a loan, you are in a better position to be approved for the loan.
Term of a Loan: The term of a loan is how long are you going to be making payments until the loan is paid off.
Some loan terms may be 12 months, 18 months, 36 months, 60 months, or in the example of a mortgage, 120 months (10) years, or 240 months (20 years).
The longer the term for a loan, the more you will pay in interest, however, the longer the loan term, reduces the monthly payment.
Ways to Reduce the Monthly Payment: If you have carefully read the terms mention prior, you can probably guess ways to reduce the monthly payment on a loan.
- Reduce the interest rate
- Extend the term
These two items have a cause and effect relationship with the loan’s monthly payment.
The lower the interest rate, the lower a monthly payment may be based on less interest paid.
Extending the term of a loan from 36 months to 42 months or longer, will also reduce the monthly payment, however you can pay more in interest.
It is crucial to understand these terms as if you find a loan you require to be slightly unaffordable, you may be able to “tweak” it with the lender to make it affordable.
Of course it all comes down to the lender agreeing to the tweaking.
Showing Affordability – Ways to Guarantee You Are Approved
Here is where we really get down to the heart of it all, showing a lender we can afford this loan!
And this is how you do it:
Do Your Own Income and Expenditure Form: Prior to applying for a loan, complete your own income and expenditure form to see exactly where you stand. The lender may or may not require one anyway, so have one ready. This way you can show, prove, you can afford the loan.
Make sure you include all your household income, wages, tax credits etc.
If you are unsure of some of your monthly bills, wait till the bills come in and then add those figures.
You want to be as accurate as possible.
Documentation: Just as previous stated, if you don’t know a monthly bill, wait for it to come in. Save all your account statements and wage slips. If you have gone “green” as many of us have, you can print out statements for the account online, or ask your bank or who you have the bill with to provide a statement.
If you are a tenant, getting a reference from your landlord won’t hurt either. You can show your tenancy agreement as to document what your monthly rent is, and have your landlord state you always pay your rent in a timely manner.
Savings: Showing a pattern of savings. Showing that you are saving money each month shows you have a surplus of income to save. This may be used to aid in making a new monthly loan payment.
Phantom Payments or Paying Yourself: This is not receiving money from some place in thin air, or paying a ghost, but showing you have already been making payments, each month, before you even received the loan, and can show you can afford these monthly payments.
It is similar to saving money each month, but if you don’t have a regular pattern of savings, and you are looking for a loan, and the loan payment may be £150 each month. For a few months or longer, begin putting aside £150 each month, just as you were making the loan payment to yourself.
Being able to show you can comfortably make this payment each month not only shows affordability to a lender, but gets you used to making the monthly payment.
Of course you may say, if I can save the money each month, or pay myself each month, why do I need a loan??
Good question, and maybe you don’t need a loan, just save up for what the loan may be to purchase.
OK, let’s move onto Execution of this process of not just being able to afford a loan, but getting the loan.
Chapter Two: Execution
And no not the type of execution you may think about when Henry VIII, or old French Monarchs come to mind, but execution of applying for a loan. What to show, what to look for, and things to know and be aware of.
The actual applying for the loan.
The more you know, as in “knowledge is power”, the better off you will be.
We will also go over ways to show affordability, not only that you can afford this loan, now and for the foreseeable future, but also some ways to “strengthen the deal”.
And also what to do if a lender throws us a curve, and we need to change our tactics.
We already know what terms may be used in getting a loan, such as the interest rate or APR, the term of a loan (how long the loan is for), and that we can show we can afford the loan as we have completed our own income and expense sheet, so what next?
Find a lender, and apply for a loan.
Where to Apply??
Swing a cat and you will hit a dozen banks or loan companies.
(I am not literally saying swing a cat, it is a saying, so all the cat lovers out there, myself included, can calm down and not write in)
If you just do a quick Google search for loans, there are dozens, if not more lenders out there ready to give money to borrowers, of course for a fee/interest rate. And of course to those borrowers that can afford to repay the loan.
And with much of the banking and lending world now being done online, an online search is one way to begin the process.
You can also go to your local bank, if there still is a branch nearby, or simply phone them to inquire about their loans, and rates and terms.
One thing to watch out for and be aware of is administration or application fees for a loan.
Some of these fees can be quite high, and are no guarantee you will be approved for a loan. They just cost you money, and it may be money you plan to use to afford payments on your loan.
Now where were we….
You are in the gathering of information stage. You have done your work as to getting the documentation together to show you can afford the loan, now you need to know what lenders are offering.
What interest rates are available, loan terms or how long will they lend for, and also the amounts they will lend.
And we want to gather this information, without actually applying. Making an application causes a footprint on our credit file, which can reduce our credit score. So for now, we are just getting information.
So if a lender begins to ask details about your address, wages, expenses, etc, just explain, I only want to know your terms. Granted, those terms may not be for everyone, but it gives you an idea.
Many lenders on their web sites show a “representative APR”, which gives us an idea of rates, but may not be the rate you will receive.
It just means that 51% of applicants received this interest rate.
And don’t forget to put pen to paper, take notes and document each lender’s rates and terms. This is what you will need to refer back to in deciding where and with who to apply.
Use Loan Calculators: Using an eligibility checker is good to find out if you may be approved for a loan, but again, they do not show monthly payments or take into account affordability.
Once you have done your research you should use a loan calculator to calculate what your monthly payments will be based on the amount of the loan, the interest rate, and the term of the loan.
This will allow you to see if the monthly payment is within what you know you can afford, and better yet, what you can show you can afford.
If the monthly payment seems a stretch, ask yourself these questions:
- Do I require that exact amount in a loan? Can I reduce the loan amount?
- Is the interest rate high, can I get it reduced and if so, where does the interest rate need to be to make the loan affordable to me?
- Can I extend the term of the loan to reduce the payments? (Remember the correlation between interest rates and the term of a loan and how we can reduce our payments with these.)
Granted, only one of these is really within our control, the amount we borrow, but having knowledge of terms and interest rates, and using a calculator to plug in the various components, will help in knowing in fitting the loan we need in with what we know we can afford.
Strengthening The Deal
OK, you know you can afford the loan, but perhaps the lender is nervous, in part maybe due to you having poor credit in the past, or no credit.
What can you do to strengthen the deal?
If you can show you can afford a loan, that can be half the process of getting a loan, however, if you have had some very poor credit in the past, such as CCJ’s, defaults, repossessions, and the such, even showing that you can afford a loan, may not get you the loan.
You need to “up the ante” as they say, raise the bar to increase your odds of being approved.
One way to do this is to get someone to co-sign for you on the loan. Especially if you have a partner or spouse whom you reside with, they could co-sign for the loan, making them just as responsible for the loan should you default, but also increasing your ratios even better if they work and have earnings.
Two (2) incomes are better than one.
The lender may also review the co-signer’s debts as well, but in many instances, having a co-signer strengthens a loan for the lender.
Guarantor: A guarantor is similar to a co-signer, however, they are only guaranteeing the loan should the borrower default on the loan. Having a guarantor does not change affordability, of or for a loan.
You still need to be able to afford the loan, but should you default, the lender has someone they can have repay the loan.
Collateral: For loans such as mortgages, and many car loans, the property, or the car, can be the collateral for the loan; the collateral secures the loan. Should the borrower default on the loan, the lender has something physical they can repossess or take back to offset any losses they may experience.
Other assets, such as shares in a company, savings accounts, or any other form of asset, may be pledged as security for a loan.
Anything that has a value, could be used to be pledged for a loan. It could be a car, such as in the form of a logbook loan, or even expensive wines.
Something that secures a loan, increases the probability of a lender granting the loan.
Even if someone owes you money, such as in a business being owed receivables, these can be pledged to secure a loan.
So now we have done our preparations, and executed our search and made application for a loan.
And we have been approved!!
However, things are not over just yet.
While the lender may feel we are good for the loan, and we are, there can be some things that life throws in our way, which could affect us repaying a loan, things that we may wish to try and be ready for.
So let’s get out our money/financial crystal ball and try to look further down the road.
Chapter Three: Sustainability
As I previously mentioned, this chapter is not about insuring there are fish in the seas for the times to come, but to insure you can afford to repay a loan in the days, years and times to come.
You have done a lot of work and research to get where you are, approved for a loan you can afford, so insuring you can always afford the loan, while no one knows the future, can help in sorting through any future financial changes.
As we discussed, some loans are for a considerable period of time, years. Much can change in our lives in those years.
For loans as large and as long as a mortgage, a lender needs to take a snapshot of us financially now, and project it ahead 10 or 20 years, seeing how we may repay the loan in that time.
There are no crystal balls which can advise us, or a lender as to what may happen in the future, and while much of what we are going to discuss here is speculation, and also not something you would be required to disclose to a lender in order to be approved for a loan, we would be remiss if we did not look at contingencies just in case.
Prepare for the preverbal rainy day.
This “disaster” can be in many forms, but the main outcome from this disaster is you find you can no longer afford to repay a loan.
This can be through:
- Loss of a job
- Reduction in earnings
The main point is something has occurred to cause you to no longer be able to pay back a loan. Your affordability has drastically changed for the worse.
One question ask oneself in these situations may be, is my situation going to get better? Is this just a transient thing, or is it permanent.
That can be the point where we know we need to look further ahead at options.
In looking at immediate options to this issue, we also need to think about how the short-term solution may fit in with any longer term solutions.
If we are most definitely facing insolvency and bankruptcy, are the funds we have now better spent saving for this solution than trying to fix a leak that will eventually burst the dam.
Some short-term options would be:
- Prioritise your bills: First things first, you need to prioritise your monthly expenses.
Bills such as rent or a mortgage payment, gas, electric, council tax, food, etc, are all priority bills that must be paid first. Then you can look at any other secured accounts/debts, and then credit cards and unsecured accounts.
- Speak to the lender: Keeping the lender in the loop is important, as then you know what is happening with the account. In many situations, unless the account has gone into default, there may be little a lender can do for you. However, they may be able to put you on a reduced payment plan for a short period of time, a payment holiday; especially if your circumstance may change soon.
- Payment insurance: Did you take out payment protection insurance on the loan if it was offered. If so, this may pay/cover the monthly payment for you for a period of time.
- What money do you have readily available: Sitting down and again putting to paper, what liquid money do you have available to you. And I am not speaking of money running out of a tap like water.
What savings do you have, and projecting what money you have, and what you may receive as any income, how long can you last by prioritising your bills?
You may find that some of the short and long-term options go hand-in-hand, such as seeking benefits, looking for other work and can be used at similar points; other options, such as liquidating assets, many may wish to use these as a sort of last resort.
What benefits or other sources of income are you eligible for: You need to bring more money into the household, how can you do this?
Inquire as to any benefits you may be entitled to. There are calculators online you can use to find this information out. Any additional income can be helpful.
Obviously if you can work, looking for work is a part of the overall plan.
Redundancy payout: If you have been working at the same employer for a few years, you may be entitled to a redundancy package or payment.
Depending on the amount of money you receive, and also your full situation, you may need this money to pay priority bills for a period of time, such as the rent, mortgage, utilities, food, etc.
If the amount of debt you have is less than the redundancy payment, or again depending on your complete circumstance, you may be able to pay off the accounts completely, or possible settle the accounts for less than what you owe.
Settlements are possible, but the accounts usually have to be in default and seriously in arrears.
Liquidation of any assets: Not the best option for many people, but what can you sell to raise some money.
Using eBay or Gumtree or other web sites, you may be able to sell some unwanted items and make some fast cash.
If you have equity in your property, and may no longer be able to afford the house, selling it may be an option, although one many may wish to avoid.
Debt management options: This option is where you seek third-party assistance in handling your accounts. You can either look at a token payment plan, or a debt management plan.
These plans allow you to pay what you can afford to pay each month, after you pay your living expenses.
The same way you went about figuring your affordability for a loan, is the same way you calculate what you can afford to repay your creditors, only on a reduced scale.
Insolvency options: These are more formal arrangements to repay your accounts, and involve the courts or insolvency practitioners.
We must keep in mind that any arrangement, creditor approved or not, that involves payments that are outside of, or different, than the original agree for the loan, can have an impact on your credit score and credit rating.
We are not here to dwell on the negative, nor is this part of your affordability plan that you would present to a prospective lender, it is for your peace of a mind. A plan, just in case you were to find yourself in a position of struggling to repay a loan.
Again, it is all about being able to afford a loan from the beginning, the application process, on through to the last payment, and the loan is paid in full.
As you reach this point in our sharing of how to afford a loan, you should feel more confident in what a lender may be looking for in granting a loan, and how you can show you can not just afford the loan, but also some options to adjust the monthly payment if needed, and also some ways to completely insure you are approved for a loan.
A couple of points need to be made, one is at the beginning of the loan application process, and one is for after you receive the loan:
- Just because a lender does not carry out an affordability check does not mean you should not do one.
There are lenders today that base their lending criteria strictly on credit scores and credit history, and miss out on affordability.
This, as we have seen, does not take into account being able to afford a loan. Past credit history and payment history is an indicator of being able to pay back a loan(s) in a timely manner, but does not show affordability.
Some lenders were actively granting loans to people who could not afford them, this form of “irresponsible lending” in the end hurts both parties, the borrower and the lender.
You need to know you can afford a loan, regardless of if the lender checks into this or not.
- Once you have your loan, don’t make drastic financial changes.
There is a saying called “old sofa syndrome”, and it is where someone my purchase a property, or be approved for a loan, and while they are at their financial strongest when approved for the loan, they use this strength to make other purchases, and their old “stuff” now needs to be replaced.
In essence what they do is get over-extended and in debt quickly, and the one loan started it all.
At the time their credit and affordability was good for the first loan, and they then exploited that good credit and affordability fortune, and made additional purchases and took out more loans and credit.
As we can see, affording a loan is an ongoing process. We must always be aware of our spending habits, and know what we can afford.
And as you can see from our little experiment at the beginning about knowing how much money we have on our person, we may not know what or how much we can afford each month towards a loan.
That is why planning, documenting, and doing some research, will not only guarantee we get approved for a loan, but also that we can sustain payments for a loan, and continue making payments until the loan is paid in full.