Regardless of the loan you’re applying for, all lenders should conduct a number of checks to determine whether you can comfortably afford the loan. As part of the Financial Conduct Authority’s (FCA) responsible lending rules, all financial institutions lending money to customers need to consider a number of different factors to ensure that the applicant in question can afford the loan and comfortably make the repayments.
From personal loans now to traditional banking institutions and building societies, all reputable financial bodies should follow FCA guidelines. Being able to do so protects the consumer and the business, but how exactly do they determine affordability and eligibility for their loans? We’ve investigated, below.
The FCA Ruling
As part of the FCA’s CONC 5, it was stated that all lenders looking to enter a credit agreement with any customer needed to assess their creditworthiness and affordability before accepting the loan. This was to protect the consumers against any adverse effects on their finance from taking out the loan. A number of factors were listed for businesses to take into account, including:
- The credit being applied for
- The amount of credit
- The cost of the credit
- The financial status of the customer at the time of application, including their ability to make repayments from their income
- The customer’s credit history to determine if they are, or have experienced financial difficulties
- The existing and future financial commitments and how these would affect their ability to meet repayments
- Any upcoming future changes in circumstances, such as retirement
- Any understanding by the firm of mental capacity concerns from the customer, or where they are considered vulnerable
They also stated that businesses could take into account additional information when determining affordability and creditworthiness, including:
- Previous dealings with the customer
- Income and expenditure
- Credit reference agency report
- Additional information or circumstantial details provided by the customer.
There were also prohibitions introduced that would protect customers from undue and unfair practices from lenders. Under these legislations, any financial firm could not advise or encourage customers to enter credit agreements of a higher sum than originally requested in cases where affordability would not be present.
Firms also needed to ensure that the application was completed in full, but only by the customer. They are forbidden from completing parts of the application which are intended to be completed by the customer without the consent of the customer themselves unless given express consent and the customer can check the application before any agreements are signed. Firms also can’t accept applications where they believe some of the information may be incorrect or misleading, within reasonable grounds, such as when the details on the application don’t match credit reports.
In order to lend responsibly, lenders have a number of checks they need to conduct prior to accepting your application and the core one in place today is an Affordability Assessment. This will take into account standard law, as well as your income and expenses and your credit score. Lenders can also consider the term of the loan, whether you’re making a down payment, whether there is collateral and your employment status and history. As part of an affordability assessment, the lender may request:
- Your ID – This can be a passport, driver’s licence or another form of recognised, legal identification
- Proof of Address – This can be a driving licence, bills or official government correspondence. Check with the lender as to what they can/will accept
- Proof Of Income – This can be a recent payslip from your existing job.
Different lenders will have different criteria for which applications they will and won’t accept. However, most will check the same, or similar details in order to determine which applicants can afford and are trustworthy enough to warrant lending the desired loan amount. In general, however, lenders could look at:
Standard UK Law For Loans
At a base level, all lenders who want to legally lend to consumers should meet the FCA’s minimum standards and achieve FCA authorisation. All lenders need to submit a business plan to the Financial Conduct Authority that details different criteria dependant on the type of firm applying. Credit lenders, for example, need to including a summary of their position in the credit market, details of their security or guaranteed and details of how employees or agents in the firm will be paid, while pawnbrokers would need to detail the procedures for mitigating the risk of fraud and how they ensure the accurate valuation of items.
For consumers, FCA approval ensures that they are being treated fairly but for lenders, it gives them guidelines on what they need to check prior to accepting an application so that they adhere to the rules. This can include only lending to applicants in the UK, to consumers over the age of 18 and only to those who pass affordability checks and are on a regular income.
Your Credit Score
As you might expect, all lenders will check your credit score when it comes to determining whether to accept your application. While it isn’t always the only factor they take into account, it is a guide for lenders to determine how trustworthy you are financially. Throughout your credit history, any decisions, credit, loans or activity you’ve had can be given a score, alongside any facts about you and your current situation. These points are added together to give you a score and the higher that score, the more trustworthy and credit-ready you appear.
Most lenders will have a limit on the credit score they’ll accept, but some may lend to someone below that limit in cases where things like your income and the loan term or cost suggest you may be able to afford it regardless.
Your credit score will often be calculated by Credit Reference Agencies (CRA), who gather a number of different details about you in order to determine your financial history and put together a credit report and score. These agencies are allowed to collect this data and will store it on a private credit reference file, which can only be accessed when you sign a form or agree to terms that allow the lender to use the information provided in order to decide whether to lend to you.
CRAs will check:
- The Electoral Roll for any addresses where you were and are registered to cote.
- Public records, including court judgements, IVAs, Debt Relief Orders, bankruptcies and Administration Orders.
- Account information for your existing accounts to determine how you handle your finances
- Home repossessions, where applicable
- The people you are connected to financially, such as a spouse, someone you have a joint account with or someone you have applied for credit with
- Previous searches on your report from other companies
- Linked addresses that you have lived at
The information in your credit report is usually kept for six years, however, some details may be kept for longer where necessary. This includes any bankruptcy restrictions or warnings provided by the court, who deem it should last more than this six-year period.
You have the right to request a copy of your credit reference file and ask for any information to be removed that has been kept for more than six years without court ruling. Additionally, if any of the information on your credit file is wrong, you can issue a notice of correction in order to change this.
Your Income And Expenses
Your income is a key player when it comes to applying for loans. Lenders will always look at your current financial decision when deciding whether you can afford the loan at hand, including information about your current outgoing expenses. These expenses will only include your fixed obligations every month, such as mortgages, phone contracts, car payments and insurance, and more. For this reason, those on a high income aren’t guaranteed a loan acceptance, as a high level of outgoing expenses could disrupt the debt-to-income ratio and mean a loan isn’t affordable.
In a lot of cases, the debt-to-income ratio is used by lenders to determine whether you have enough disposable income to handle the repayments on a loan. In cases where your credit score may be high, the set ratio by a lender can be flexible to account for your deemed creditworthiness. This isn’t the case for every lender, however, so bear this in mind when applying for any kind of credit, loan or finance.
The Loan Term And Cost
The cost and term of the loan can have an effect on whether or not it is affordable for you in your current situation. In some cases, a loan that lasts longer may work out more affordable for the consumer, however, there are cases where a shorter-term loan may be deemed most suitable for affordability. As part of affordability checks and the application review process, lenders should take into account your requested loan amount and cost and may require you to change the term of the loan to cater for this affordability.
As the borrower, you can often calculate loan terms before you even apply. This way, you can determine whether a shorter-term or longer-term loan will work best for you. Bear in mind, however, that longer-term loans often accrue more interest than a shorter loan and so the overall cost will be higher.
Some loans offer you the opportunity to put forward an initial down payment, which lowers the amount you’ll need to pay overall and therefore lowers the risk to the bank. By doing so, banks and credit firms may be more willing to offer you the loan or credit you have applied for. When you take out a mortgage, for example, you are often required to offer a down payment of a recommended 20% of the overall cost. That could amount to £50,000 on a £250,000 loan. While this can seem scary, it will help to lower the upfront fees, lower your ongoing loan fees and offer a lower monthly payment.
Similarly, you can offer down payments on car finance to help cut down the monthly payments. While some people can offer a larger chunk than others, down payments do offer you a better hold on the vehicle to begin with and can give you the chance to purchase a better car than you might be able to afford otherwise.
Loans that require collateral are referred to as ‘secured’ but can offer you better rates than an unsecured alternative. This is because the risk to the lender is much lower, as they will have an asset available to seize if you are unable to make the loan repayments. In most cases, the collateral offered will be of the equivalent price of the loan but will offer you a higher chance of acceptance, even with a poor credit rating. If you were taking out a loan of £5,000, for example, you would need a vehicle or alternative asset of the equivalent value in order to be accepted.
Mortgages are a form of secured loan, as the property being purchased will act as the collateral. Regardless of the loan amount, you need to ensure you can afford the repayments regardless so that you don’t default and lose possession of your asset.
Employment History And Status
You need to be employed in order to take out a loan and in some cases, a lender might even require you to be in full-time employment, rather than part-time or self-employment. Lenders might also take into account your employment history to determine whether your current income is stable enough to warrant a longer-term loan. For example, if you’ve jumped from job to job in the past couple of years, the lender may deem you to be a risk due to a previously unstable income.
When lenders are determining the affordability of a loan, they are doing so with your best interests in mind. While it can be frustrating if you’re struggling to be accepted, this could be due to the lender deeming that you cannot afford the loan repayments. Check your credit report and your debt-to-income ratio, and take action where needed to strengthen your financial standing.