Posted on: May 9, 2023
How does a lender consider how much they will lend?
11-07-2023 Correct at time of publication, but subject to change
Firstly let’s look at the history behind the current philosophy on lending now. Prior to the bank crash in 2008 lenders were far less careful about the amount they lent and the risks they took. And sure enough this contributed to the crash. 2008 to 2012 saw a significant recession, bank bailouts and significant property price reductions. In the aftermath there was a period of consultation to assess what had gone wrong, both with how lenders had acted and of course how regulators allowed the situation to happen. The Financial Services Authority disappeared in 2013, being replaced with the Financial Conduct Authority to regulate conduct and the Prudential Regulation Authority that regulates risk.
Whilst both organisations now regulate lenders it is the Prudential Regulation Authorities job to specifically govern the risk that lenders take. Part of this governance deals with how much they lend, what exposure the lender has, and the insurance funds put by if a loan defaults. So when a lender makes an offer of loan it is these guidelines that they go by in making the decision.
If we ignore the decision to physically lend you the money which also includes such matters as your credit file and credit score, we are left with the lenders affordability calculator.
A lenders affordability calculator is a more bespoke calculation based on the borrowers financial circumstances. Some of the considerations within the affordability calculator are:
- The borrowers main income, whether they be employed or self-employed.
- How the lender might take into account any variable pay such as overtime, bonus or commission.
- How the lender might take into account any secondary income such as a second job, Child Benefit, Disability living allowance, maintenance or investment income.
- The term of the loan. Longer terms generally (but not always) result a higher amount of loan being available.
And once they have assessed this they need to take into account the borrowers commitments and how they might affect the borrowers ability to meet the monthly payments such as:
- The amount of short-term unsecured credit that the borrower has, the monthly payments and how the lender interprets this into making the affordability decision. Short-term credit can include, personal loans, car loans, car Leases (PCP’s), student loans, credit cards, store cards, interest free credit or buy now pay later arrangements.
- Other personal expenditure considerations such as maintenance payments, school fees, education costs, child care costs and costs that only some lenders will consider such as pension contributions, travel costs and rail season tickets.
- How many dependents does the borrower have, the more dependents the greater the family expense and thus the less a borrower might be able to borrow.
- How old is the borrower and when do they expect to retire. This may reduce the mortgage term and thus reduce the amount available.
And finally what risk is the lender taking, is this a borrower with a 40% deposit which will ensure the lender has to put less aside for potential mortgage default, or is this a 95% loan to a first time buyer where the amount a lender has to hold in cash to protect against default is considerably higher. Typically the higher loan to value loans such as 90% or 95% have lower maximum caps as they generally carry higher interest rates to protect against the inherent risk and the cost of offsetting the lending risk to the lender in question.
Once all of the parameters are known your adviser can input the details into a portal that will then create a report that will highlight what many of the lenders will lend as a maximum amount. Each lenders calculator is different, but most will have an algorithm that will factor in the average costs for gas, electricity, water and council tax, and for example the average cost of food, the cost that each dependent brings and other basic factors. Once these costs and the variable factors are entered the calculator will provide a maximum borrowing figure. The borrowing figure will not only calculate the affordability based on the current interest rate, but also a default interest rate that is considerably higher, it is this figure that the lender will offer. This is to protect the borrower against potentially rising rates in the future as well as meeting some of the lenders obligations to protect borrowers and insure against the risk of default.
Your adviser will discuss the maximum figure with you including what this might cost. For your own personal affordability you may decide that the maximum loan is unaffordable, in which case your adviser will help you understand how your budget converts into pounds borrowed.
