How Do Lenders Determine Your Ability to Pay for a Loan?
It is an all too common scenario. You do the math, and you are fairly certain that you can easily afford the particular loan that you are applying for. You have considered your monthly living expenses, other mortgages, etc. in calculating the monthly payment that you can afford. So that loan should be in the bag, right? Well, not to rain on your parade or anything, but it is still not a sure thing.
You should know for a fact that lenders have their own way of calculating your ability to pay off a loan. And really, it is considerably more convoluted than your own method in such a way that theirs include a lot more factors that you may not have considered to be significant, or have even heard of. If you look at it from the lenders’ perspective, this actually makes sense as they are the ones undertaking a considerable risk in parting with their money to lend to a relative stranger such as yourself. So really, we can’t blame them if they require you to jump through some serious hoops and provide an avalanche of documentation.
Know where you stand on the HPI.
First of all, they base living expenses off the Henderson Poverty Index or HPI. Basically, you belong in a bracket and will be assessed as such. Secondly, each lender also has their own unique serviceability calculations, which can be rather mysterious to outsiders.
Other than these, however, it is still all fairly straightforward. Both the living expenses based on the HPI and your actual living expenses will be subtracted from your income after taxes. These non-HPI living expenses include your house mortgage and/or rental, monthly bills and other regular ongoing expenses, other loans, and, of course, your credit cards. Which brings us to the next point . . .
Beware the credit card.
You may think that credit cards will be a non-issue, especially if you pay for it in full every month. However, lenders will always calculate the expense amount as a percentage of your total credit limit as these are still funds that are accessible for you, which you could potentially borrow from later. Paying your cards in full every month holds absolutely no weight, we are sorry to say. Their logic is that you could easily fully use up your credit cards right after you get your car loan; hence, it is classified as an expense.
On the flip side, having a less than stellar credit card payment history also puts you at a disadvantage. This lowers your credit rating, which is a real red flag to lenders as it shows them that you are a less than stellar candidate for a loan because of your historical inability to pay.
Your status counts.
Another thing that lenders would carefully consider is your marital status, as well as the number of children and/or dependents that you have. Different lenders approach this factor differently. For some lenders, having an income-earning spouse or partner is a benefit as this reduces your living expenses. Some lenders, on the other hand, will actually require an income-earning spouse or partner to act as co-borrower to the loan as an added requirement to show your capacity to pay. Again, it is a bit confusing how lenders decide to go one way or the other.
It is also rather ambiguous how lenders classify “income.” Some families are eligible for tax benefits, and different lenders would allow different percentages of these tax benefits to be considered as usable income. Ditto with other income sources, such as government pensions, dividends from shares of stocks, and even rental income from properties to own.
Regardless of what they will allow or what they will ignore in terms of computing your income, however, lenders will always agree on one thing—you will need to have a considerable surplus left over from your total income after all the standard living expenses are subtracted. This surplus must be more than enough to cover the monthly payments for your car loan as there needs to be a buffer left over. While some lenders are content with a buffer of just $1, more lenders would actually require a lot more than that.
Indeed, having a rough idea of how lenders operate gives you a real advantage when it comes to preparing your loan application. Do your homework and make sure that your paperwork is in order to give you a higher chance of success.
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