When considering a loan, understanding how lenders calculate your affordability is crucial. Knowing the factors they assess can help you prepare and make informed financial decisions. It’s important to remember that lenders are primarily focused on profit, not necessarily on supporting your financial well-being. Additionally, they are risk-averse and will ensure they can reclaim your assets if needed.

Let’s explore how banks determine your affordability, the pros and cons of relying solely on their assessments, and how you can calculate your own affordability to make sound borrowing choices.

How Lenders Calculate Your Affordability

When you apply for a loan, banks and other financial institutions evaluate your ability to repay it through an affordability assessment. Here are some key factors they consider:

1. Income

Lenders assess your total income, which may include your salary, bonuses, rental income, and any additional sources of income. They typically require proof of income, such as payslips or tax returns.

2. Expenses

Your regular monthly expenses significantly influence how much disposable income you have for loan repayments. Lenders will evaluate your living costs, including rent or mortgage payments, utilities, groceries, and recurring expenses like insurance.

3. Credit History

A lender will check your credit report to assess your creditworthiness. A good credit score reflects responsible borrowing behaviour, while a poor score may indicate potential repayment issues.

4. Existing Debt

Lenders consider your current debt obligations, including credit card balances, personal loans, and other debts. This helps them gauge how much additional debt you can manage.

5. Loan Amount and Term

The amount you wish to borrow and the loan term (duration) will impact your monthly repayments. Lenders use these factors to determine if you can comfortably afford the loan.

Don’t Solely Rely on Lenders’ Affordability Assessments

While lenders are experienced in assessing credit risk and their calculations are based on comprehensive financial models, it’s crucial to recognize their limitations. Lenders may have a vested interest in lending you money and could underestimate your financial constraints to secure a deal.

They typically focus on their criteria and may not consider your unique financial circumstances, leading to a misalignment between your actual capabilities and their assessments. Additionally, a lender’s approval can create a sense of obligation to accept the loan, even if it may not be the best choice for your financial health.

Determine Your Own Affordability

To borrow responsibly, it’s wise to calculate your own affordability before approaching a lender. Here’s how:

1. Calculate Your Monthly Income

Add up all sources of income, including salary, bonuses, rental income, and any side hustles.

2. List Your Monthly Expenses

Create a comprehensive list of your monthly expenses, including:

●   Housing costs

●   Utilities (electricity, water, internet)

●   Groceries

●   Transportation (fuel, maintenance)

●   Insurance (health, vehicle, home)

●   Debt repayments (credit cards, personal loans)

●   Discretionary spending (entertainment, eating out)

3. Determine Your Disposable Income

Subtract your total monthly expenses from your total monthly income to find your disposable income. This is the amount you can allocate towards loan repayments.

A common guideline is the 28/36 rule, which suggests spending no more than 28% of your gross monthly income on housing expenses and no more than 36% on total debt repayments (including housing and other debts).

4. Use a Loan Calculator

Utilise an online loan calculator to estimate how much you can afford to borrow based on your disposable income and the loan terms (interest rate and repayment period). This will provide a clearer picture of what’s manageable.

The Bigger Financing Picture

Understanding how lenders calculate your affordability is essential when considering a loan. While relying solely on lenders might be convenient, it may not always reflect your true financial situation. By taking the initiative to calculate your own affordability, you can make informed decisions that align with your financial goals.

If you are already overburdened with debt, Debtgrip is here to help.
www.debtgrip.co.za