How lenders judge loan repayment affordability and why this is important to you

There are many factors involved in being approved for credit. However, perhaps one of the most important today is affordability. Changes in the personal finance market over the past decade have put affordability at the top of the list of criteria that lenders must establish before they decide to approve a loan application. But what kind of tests do lenders use to measure affordability and what does it mean for you if you don’t pass them?

How credit providers judge affordability

The basis of affordability is whether you can borrow the personal loan – or use the credit card that you’re applying for – and be able to make the required repayments. And once you have made the repayments, will you still have enough disposable income to make other essential payments, such as mortgage or rent, the cost of food and transport.

So credit providers will need to know your monthly income (net of taxes) versus your monthly outgoings. They will probably try to distinguish between your discretionary costs (i.e. those things you can choose not to spend money on e.g. your socialising) versus non-discretionary (i.e. those costs you can’t avoid, such as food, energy, rent/mortgage payments & travel, etc).

How much you earn – the more you earn, the more income you have to cover repayments.
Your outgoings – the higher your monthly outgoings, the more unaffordable new credit is likely to be.

But don’t get affordability mixed up with creditworthiness. Your creditworthiness needs to be strong too. If you can afford the loan repayments but your repayment behaviour has been poor (as recorded in your credit file at the credit reference agencies) they may still refuse to lend to you. You need to be able to demonstrate that you can afford the loan repayments and that you actually do make the repayments on time and in full.

So credit providers will also use your credit report to help them make a judgement about whether to lend to you. They don’t use the credit scores generated by credit reference agencies but, instead, will use the information in your credit report to generate their own. The following factors will have an influence over how credit providers assess your credit worthiness:

The amount of debt you already have – if you are already making payments on multiple debts then lenders might not feel it would be affordable for you to add to that.
The ratio of earnings to debt – high earnings and low debt is the optimum to demonstrate you can afford credit. However, middle income earnings and low debt may work too, as well as other combinations. If you have low earnings and high existing levels of debt then you may struggle to get further credit.
Public records – your credit report will demonstrate to a lender whether you’ve struggled with borrowing in the past, for example if you’ve had a court judgement against you. Although this doesn’t go to the heart of affordability it will demonstrate how easy you find it to manage debt.
Your financial associations – your credit report will also show a lender who you are connected to financially. If a current or ex partner has a very negative credit report, for example, it could mean a lender assumes you might end up being responsible for their financial situation and unable to afford your own obligations.

Why does affordability matter?

There is now an increased focus on responsible lending, particularly in the short-term credit sector. The UK Financial Conduct Authority has issued official guidance that makes it clear that a credit provider should not be advancing credit to a customer before assessing their creditworthiness (including affordability). This is a requirement in addition to the assessment the credit provider will do to determine the risk to itself in providing the credit to the customer. As a result, every lender will now carry out an affordability assessment so, for those looking to borrow, it is an important factor to consider.

What can you do if you’re not approved?

If you find yourself in a position where a credit provider has refused your application on the basis of affordability then there are a number of steps you can take.

Check your credit file. Look for mistakes that could have given the impression you couldn’t afford to make the repayments – or a connection to someone else who doesn’t have a good credit score.
Pay off existing debt or consolidate debt. It may be that your application was refused because you already have too much debt – if that’s the case then reducing that debt is a good place to start. Or restructure your debt to make monthly repayments smaller.
Start budgeting. If you’re not in control of your finances then you could fail an affordability test on the basis of an imbalance of income and outgoings. Learning to budget can help you to bring these figures back into line.
Look for other types of credit. Affordability criteria vary from lender to lender. You may also find that a different type of credit is a better option. For example, a homeowner loan – which uses your property as security – could result in an approval where an unsecured loan application did not.