How Does a Lender Decide Whether To Lend Or Not
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Author: Scott Neson
Creditworthiness is a lender’s willingness to trust you to pay your debts. A borrower deemed creditworthy is one a lender considers willing, able and responsible enough to make loan payments as agreed until a loan is repaid.
How Does a Lender Decide Whether To Lend Or Not
1. Affordability
Affordability means how difficult it may be for the customer to repay.
Lenders will assess your affordability throughout the time-span of your loan with them. But the most important assessment comes at the initial application stage, where lenders will assess whether you’re eligible for a loan (creditworthy).
They have to make a reasonable and proportionate assessment. They will assess affordability from two angles: your ability to repay the loan vs the affordability of the loan and the repayments. It’s very hard to get a loan with poor creditworthiness.
What factors determine your affordability
To judge your creditworthiness, lenders look at the following factors:
- Evidence that you pay your bills
- Level of debt
- Financial vulnerability (see below)
- Levels of income
- Effective Disposable Income (see below)
- Credit report and score
What Factors determine the affordability of the loan?
To judge the affordability of the loan, lenders look at the following factors:
- The size of the lending commitment
- The time-frame
- The interest or fees
The lenders then use data to contextualise your financial circumstances, in order to better understand them.
They look at whether your income is stable, whether it is increasing or decreasing, and how much disposable income you might have. They also look at debt to income ratios.
2. How Does a Lender Decide Whether To Lend Or Not: Effective Disposable Income
This is the metric lenders use to really understand somebody’s capacity to pay.
They take monthly disposable income. Then they deduct rent, essential spending, the basic quality of living spending (such as household goods), and deduct repayments.
The income that’s left will be used to calculate how much you will be able to afford to repay over a certain period of time.
3. Vulnerability – are you too vulnerable to borrow?
There are four key drivers that lenders use which increase the risk of financial vulnerability.
- Health.
Health conditions or illnesses that affect their ability to carry out day-to-day tasks. - Life event.
Major life events such as bereavement, job-loss, or relationship break-down. - Resilience.
Low ability to withstand financial shocks. - Capability.
Low knowledge of financial matters, low confidence in managing money, or low capability in other relevant skills such as literacy or digital skills.
Vulnerability has sharply increased in the UK due to the pandemic. One and a half million more people were displaying signs of vulnerability in July, compared to February. The percentage of adults with low financial resilience had grown to 23%: that’s 12 million adults.
If any of these drivers align with your circumstances, you should avoid further borrowing. These factors could increase the risk that you make financial decisions that will damage you further down the road. Lending firms will look at your vulnerability when taking into account whether you can afford a loan.
Case Study
This is all best explained by an example. Let’s call our example Jeff! Jeff applies for a loan of £1000 over three years. The monthly payment amount agreed is £40.
Jeff has an annual income of around £15,000. The lending firm has calculated his EDI (see above) and worked out that he has £50 EDI per month.
The firm may therefore calculate that £40 is a high monthly payment for Jeff. It is quite risky, and does not leave a buffer for if something makes Jeff more financially vulnerable. A good lending firm would then consider lower monthly repayment amounts, stretched over a longer period.
Borrowing Safely
If you do decide to borrow, make sure you choose a safe and legitimate loan provider. There is currently a growth of businesses offering possible alternatives to high-cost loans. However, some of these lie outside of the Financial Conduct Authority’s regulation. They therefore may harm customers in the long run.
An example is Employee Salary Advance Schemes. This model is extremely risky; the regulations don’t require the firms to perform an affordability check. The firms don’t check whether the people they are lending money to will be able to pay it back. This may mean that people take out a loan unsuitable for their needs, and not be able to pay it back.
Furthermore, there’s the risk that if an employee takes their salary early, it is more likely that they will run short towards the end of the next pay day, potentially leading to a cycle of repeat advances and escalating fees.
Scott is a financial services expert, with over 10 years’ experience in the industry. Troubled by the lack of moral conscience in the industry, Scott decided to use his insider knowledge to give genuine advice to those struggling financially. He’s recently moved out of London to the rural area of Malvern to pursue this ambition.
