Have you considered how a lender works out how much you can borrow?
Scroll down to cover: Income multiples, Loan to Income Ratios, Debt to Income Ratios, Mortgage Affordability Calculations and Mortgage Stress Testing!
When people are looking for mortgages and loans, often little thought is given to how a lender may work out what they deem as affordable – how much they could lend in real terms, may sometimes be overlooked by a potential borrower.
Lenders work out who could afford what in various different ways, and whilst it’s unlikely no two lenders would calculate affordability in exactly the same way, it’s likely they would be using one (or more) of the following methods.
You are probably familiar with this – the lender takes your annual salary, multiplies it by a number (depending on lender) and a lender could lend up to that amount.
3x income multiplier – annual salary of £30,000, multiplied by 3 gives £90,000 – this is the total amount the lender may be prepared to lend.
This is a very straight forward way for a lender to take your income and deem what they see as affordable, however, it may not be very accurate for working out individual affordability. It takes no account of your personal circumstances, other credit commitments and outgoings and for these reasons is rarely used alone (it takes no account of other credit commitments), if used it would typically be in conjunction with one of the other methods listed below – it is rarely used as a sole indicator of how much a client can borrow.
The lender works out your monthly income, takes a percentage of this (the % would depend on the lender) and may allow this amount to cover your monthly loan or mortgage payments (‘Mortgage To Income’ or ‘Loan To Income’):
The lender works on an MTI (mortgage to income) of 30% – they could take your monthly income (whether they take your net or gross income will depend on the lender but typically the net income would be used) and may allow 30% of that to cover the new monthly mortgage repayments. As long as your new mortgage payment does not exceed the stipulated percentage (in this example, 30%) they may deem it affordable. This is a more accurate way of determining whether a loan is affordable than the income multiplier method – it at least tries to take into account other outgoings by limiting your new loan payment affordability to a set percentage of your monthly income, however, this method still takes little notice of other actual credit commitments such as credit cards or other loans.
The lender could allow a certain percentage (set by the lender) of your total monthly income (net or gross could depend on the lender but typically it would be the net income) to cover all monthly credit repayments, including the new mortgage or loan payment. If your total monthly repayments do not amount to more than this they could deem the new loan affordable.
If you earn £50,000 per annum and the lenders DTI is 50% of your gross monthly income – approximately £2083.33 – the lender may deem the new loan affordable as long as the monthly cost of all your debts (credit cards, store cards, hire purchase agreements etc), including the new loan repayment do not exceed £2083.33.
This is a fairly effective way of ensuring a borrower doesn’t become over committed by taking on too much debt, as it stipulates that only a certain percentage of their income would be used for credit thus ensuring other living costs are accounted for. The actual percentage amount a lender may allow will be different from lender to lender and could also be different for single borrowers, couples or families. Whilst this does attempt to ensure the borrower has income left after paying their monthly credit commitments, it doesn’t take into account a households spending
This tends to be a comprehensive review of a potential borrower’s income and expenditure and would typically require an income and expenditure form to be completed.
A lender would look at what income you have coming in (wages, dividends, tax credits, other provable income) on a monthly basis and will then look at what you have going out including living costs, other credit commitments and travel etc.
They would then perform a calculation (which could be as simple as subtracting your outgoings from your income). If the remaining income covers the outgoings, including the new loan payment (dependent on what the individual lender will allow) the loan may be deemed affordable. The affordability calculation may vary for individuals, couples and families. Most lenders will use the Office for National Statistics (ONS) figures as a baseline for living costs such as food and grocery shopping – an individual living alone will spend less on shopping than a couple with two children. If someone’s outgoings are much less than the ONS figures would suggest a potential borrower may be asked to provide proof (for example via bank statements) that the outgoings stated on the expenditure form are accurate – Although, most lenders will require bank statements as a matter of course for a mortgage application.
This method ensures that a lender obtains as much relevant information about a borrower’s financial position as possible. It takes into account all any credit commitments that will remain once a new loan or mortgage has been completed and also a clients living costs – They may want to know how much you spend on socialising and gym memberships for example, ensuring that your quality of life is maintained when the new mortgage or loan completes!
Most mortgage lenders will now require a full income and expenditure assessment completing before giving a decision in principal and subsequent mortgage or loan offer (with the exceptions potentially being non regulated buy to let mortgages where affordability is typically derived from rental income and non regulated bridging loans). For this reason when going over your income and expenditure with a mortgage or loan professional it’s important not to guess at what your income or outgoings are – A lender will check and if they don’t match what was put on an application form the lender may be inclined to refuse the mortgage!
Mortgages can be stressed!
For most typical mortgages and loans the majority of lenders will use one or a combination of the above to work out if a new loan would be deemed affordable, however lenders will also ‘stress test’ income when working out affordability – Stress testing simply means that a lender will simulate higher interest rates for affordability purposes so if you have been offered a rate of interest, a lender would add a few percent on (which would increase the payments, at least the simulated payments) and will check if you still meet their affordability criteria based on the higher simulated payments. So whilst you may feel the loan is more than affordable on the rate you have been offered it’s worth noting that most lenders will not use the rate you have been offered (and the corresponding monthly payments) to work affordability, they would use a slightly higher rate – This is to ensure you can still maintain the payments should rates increase in the future and forms an integral part of a modern lenders affordability calculation.
The main thing to consider from a borrower’s point of view however, is that even if a lender deems a mortgage or loan to be affordable is not to proceed with anything until you are happy you can afford and maintain the new payments inline with your current lifestyle, or any lifestyle changes you may have planned.
If you are looking to apply for a mortgage or any loan secured on land or property, we would be happy to discuss how a lender may view your affordability relative to your individual circumstances or to discuss any other issues you feel you may need assistance with.