What Is Loan Affordability and How Does It Work?

Taking out a loan is a significant financial decision for both you and your lender. Many people often worry about whether or not they’ll be able to manage their repayments, and it’s a valid concern.

With loans hinged on your ability to handle repayments during the loan period, how can you know if you can really afford it? This is where loan affordability comes in. 

A loan affordability check measures a potential borrower’s ability to pay back their loan in full and on time. It’s based on how a lender evaluates a potential borrower’s income and expense obligations.

Many good lenders offer affordable loans in the UK, but each has specific requirements around how they assess loan affordability. Whether you’re taking out a loan to cover unexpected expenses or a significant purchase, many factors can influence your loan affordability. 

As a result, loan affordability becomes an important aspect of your loan application, making it essential to understand how it works. 

In this article, we’ll examine what loan affordability is, how it works and the key factors that impact your affordability. By understanding how loan affordability works, you can make informed financial decisions and take proactive steps to improve your chances of loan approval. 

What Is Loan Affordability and Why Is It Important?

Loan affordability is a measure of your ability, as a potential borrower, to repay a loan without compromising other financial obligations. A loan affordability check is important as it protects the borrower and the lender from any consequences of default later on. 

Lenders need to act responsibly when approving loan applications to ensure borrowers aren’t taking on more debt than they can manage. Loan affordability assessments are a security measure that helps lenders make responsible decisions to protect themselves from risk and minimise the chance that borrowers are left unable to repay the loan.

How Is Loan Affordability Calculated?

In the UK, lenders are required to calculate loan affordability based on guidelines set out by the Financial Conduct Authority (FCA). The three main criteria it focuses on are a borrower’s income and expenses, credit score, and debt-to-income ratio.

Typically, lenders employ their own formulas to evaluate and assess these three factors. Lenders are also permitted to make reasonable assumptions about a borrower’s future prospects. However, they also need to base these assumptions on data and avoid unjustified assumptions. 

All lenders must demonstrate that they had reasonable grounds to believe that a loan was affordable to a borrower prior to issuing it. They also need to be prepared to show and even defend the process that led them to this conclusion.

5 Factors That Affect Loan Affordability

Loan affordability is a very helpful tool for lenders, allowing them to understand how comfortably you can repay a loan. Let’s take a look at some of the main factors that affect loan affordability:

1) Income and Expenses

Income and expenses provide lenders with a benchmark of your disposable income. This allows lenders to examine how much money you have each month to calculate the repayments on your loan. 

2) Credit Score and Report

Your credit score is influenced by multiple factors, just like loan affordability. That said, one of the main factors that impacts your credit score, is your credit history. 

Having a long history of responsible credit use will lead to a higher credit score. Some other important factors include the level of credit utilisation and the types of credit you use. 

By understanding a potential borrower’s credit score and credit history, lenders assess how well borrowers manage their credit, influencing the terms of the loan.

3) Debt-to-Income Ratio

Your debt-to-income ratio represents the portion of your income that goes towards paying off your existing debt. This is a crucial component in lenders assessing whether to grant you a loan or not, as it will influence how likely the borrower is to make payments on time.

The debt-to-income ratio is calculated by how much of your income is paid towards debt. For example, if you earned £100 a month and £50 of that income went towards debt repayment, your debt-to-income ratio would be 50%. 

If your debt-to-income ratio is above 75%, you will be seen by many lenders as high risk, meaning they will be less likely to lend to you.

4) Employment

Employment status is another important factor that lenders use to make a judgement regarding loan affordability. Having a steady job will give lenders more confidence that you’ll have a consistent income and will therefore be able to repay the loan on time.

5) Assets / Guarantors

Some types of loans are only accessible to people with assets they can offer as a means of security. Whilst not the case for every type of loan, lenders may offer more favourable rates towards potential borrowers who offer assets as security. However, borrowers who don’t have assets may still qualify for these loans if they can offer a guarantor. 

It’s essential to remember that loan affordability highly depends on the specific terms of a loan. For example, the same lender may judge a borrower as being unable to afford a short-term, high-interest loan, but believe they’re able to afford a long-term, low-interest loan. 

Choose Salad Money for Fair and Affordable Personal Loans

Securing a loan can be challenging and passing the loan affordability check is an essential step in this process. By understanding what factors influence loan affordability and being well-prepared, you can make this journey smoother and increase your chances of approval. 

At Salad Money, we value your financial health. We understand that sometimes life can throw unexpected and costly challenges your way, that you may need financial assistance with. That’s why we offer fair and affordable personal loans to help you overcome your financial challenges. 

As a leading online lender in the UK, we offer the support you need to regain control of your money. With our ‘More Than Your Score’ loans, we provide you with the financial support you need, irrespective of your credit score. 

We use an open-banking-based assessment system to analyse loan affordability based on your current situation, rather than just your credit score. What’s more, we’re an FCA-regulated and authorised organisation, so you can trust us to keep your financial data safe