Affordability check

What Is an Affordability Check?

An affordability check is a comprehensive assessment conducted by a lender to determine a borrower's capacity to comfortably manage new credit repayments without experiencing undue financial hardship. This process falls under the broader category of lending and risk management, aiming to prevent borrowers from taking on loan obligations they cannot sustainably meet. It involves a thorough review of an individual's financial situation, including their household income, expenditures, and existing debt obligations.

History and Origin

The concept of assessing a borrower's ability to repay is as old as lending itself, evolving from informal assessments to structured processes. Formalized affordability checks gained significant prominence and regulatory backing following the 2008 global financial crisis. Regulators worldwide introduced stricter rules to prevent a recurrence of widespread defaults caused by irresponsible lending practices. In the United States, for instance, the Consumer Financial Protection Bureau (CFPB) finalized the Ability-to-Repay (ATR) Rule as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which became effective in 2014. This rule generally requires lenders to make a reasonable and good faith determination of a consumer's ability to repay a residential mortgage loan according to its terms.⁶, ⁷, ⁸

Key Takeaways

• An affordability check evaluates a borrower's capacity to repay a loan based on their income, expenses, and existing debts.
• It is a crucial component of responsible lending, protecting both borrowers from financial distress and lenders from credit risk.
• Key metrics often include debt-to-income ratio and analysis of disposable income.
• Regulatory bodies increasingly mandate affordability checks in various lending sectors, especially for mortgages.
• The assessment aims to ensure sustainable repayment capacity over the long term, not just based on introductory rates.

Interpreting the Affordability Check

Interpreting an affordability check involves analyzing various financial indicators to form a holistic view of a borrower's financial health. Lenders typically examine the borrower's gross and net income, cross-referencing it with their regular monthly outgoings, which include rent or existing mortgage payments, utility bills, and other financial commitments like existing loans, alimony, or child support. The goal is to calculate the remaining disposable income that can be allocated to the new loan.

A primary metric used is the debt-to-income ratio (DTI), which compares a borrower's total monthly debt payments to their gross monthly income. While specific thresholds vary by lender and loan type, a lower DTI generally indicates better affordability. Lenders also consider the borrower's credit score and credit history, as these reflect past financial behavior and provide insight into the likelihood of future timely repayments.

Hypothetical Example

Consider Sarah, who wants to take out a new personal loan. Her gross monthly income is $4,000. She has existing monthly expenditures including:

• Rent: $1,200
• Car Loan: $300
• Credit Card Minimum Payments: $150
• Utilities, Groceries, etc.: $800

Sarah's total current fixed monthly obligations are $1,200 + $300 + $150 = $1,650.
Her non-fixed monthly expenses are $800.
Her total monthly expenses are $1,650 + $800 = $2,450.

Her calculated disposable income before the new loan would be $4,000 - $2,450 = $1,550.

If the proposed new loan would add another $250 to her monthly payments, her new total obligations would be $1,900 ($1,650 + $250).
Her new DTI would be (($1,900 / $4,000) \times 100% = 47.5%).

The lender conducting the affordability check would evaluate if Sarah's remaining $1,300 ($1,550 - $250) in disposable income, and her 47.5% DTI, are sufficient and sustainable given the loan terms and her living expenses, adhering to their underwriting standards.

Practical Applications

Affordability checks are widely applied across various financial sectors to ensure responsible lending and consumer protection. Their most common applications include:

• Mortgage Lending: This is perhaps the most critical area where affordability checks are stringent, often mandated by regulations. Lenders assess whether borrowers can afford mortgage payments over the loan's lifetime, accounting for potential interest rate changes. The Consumer Financial Protection Bureau's (CFPB) Ability-to-Repay rule in the U.S. is a prime example of this regulatory emphasis.⁵
• Personal Loans and Credit Cards: Lenders assess a borrower's capacity to handle additional monthly payments without falling into excessive debt.
• Auto Loans: Similar to personal loans, affordability checks ensure that car payments are sustainable given the borrower's financial situation.
• Rentals and Leases: Landlords or leasing companies often conduct their own version of affordability checks to verify that prospective tenants can consistently meet rent obligations.
• Utilities and Services: In some regulated industries, such as broadband or energy, providers may conduct checks to ensure customers can afford ongoing service payments.
• Debt Consolidation: When a borrower seeks to consolidate existing debts, lenders perform an affordability check to confirm that the new, potentially lower, consolidated payment is genuinely manageable and improves the borrower's financial standing. Experian, a major credit bureau, provides solutions for lenders to verify income and expenditure to improve understanding of a consumer's financial well-being and capacity to afford credit.⁴

These checks are vital for financial planning and contribute to overall economic stability by reducing the likelihood of widespread defaults, as discussed in research by the Federal Reserve Bank of San Francisco regarding housing affordability and supply dynamics.³

Limitations and Criticisms

While essential for responsible lending, affordability checks are not without limitations and have faced some criticisms:

• Reliance on Historical Data: Traditional affordability checks often rely heavily on past income and expenditure data. This can be a limitation for individuals whose financial circumstances have recently improved (e.g., a new job with a higher salary) or those with irregular income streams (e.g., freelancers, commission-based workers).
• Static vs. Dynamic Nature: A snapshot assessment may not fully capture the dynamic nature of an individual's financial life. Unexpected expenses, job loss, or significant life events can quickly alter repayment capacity, which a static check cannot predict.
• Exclusion of "Thin-File" Borrowers: Individuals with limited credit history or those new to a country might struggle to pass conventional affordability checks despite having sufficient income, simply due to a lack of verifiable financial data.
• "Stress Testing" Limitations: While some checks include "stress tests" (e.g., assessing affordability if interest rates rise), the parameters of these tests might not always reflect extreme market conditions.
• Impact on Housing Accessibility: In highly competitive housing markets, stringent affordability checks can make it more challenging for first-time buyers or lower-income households to access mortgages, potentially exacerbating housing affordability crises. Research from the International Monetary Fund (IMF) has highlighted the global housing affordability challenge and the limitations of traditional price-to-income ratios in capturing the true cost of financing.¹, ²
• Data Verification Challenges: While lenders strive to verify financial information, instances of income misrepresentation can occur, potentially leading to loans that are not genuinely affordable for the borrower, posing an ongoing credit risk.

Affordability Check vs. Debt-to-Income Ratio

While closely related and often used in conjunction, an affordability check is a broader process than simply calculating the debt-to-income ratio.

An affordability check uses the DTI ratio as a key input, among many others, to paint a complete picture of a borrower's financial standing and determines if they can truly afford a new financial commitment. The DTI is a critical component but not the sole determinant.

FAQs

What information is typically required for an affordability check?

To conduct an affordability check, lenders generally require detailed information about your income (e.g., payslips, tax returns, bank statements), regular expenditures (e.g., rent/mortgage, utilities, food, transportation), and existing debt obligations (e.g., other loans, credit card balances, alimony, child support). They also typically review your credit score and credit history.

Can an affordability check negatively impact my credit score?

The initial inquiry for an affordability check might involve a "hard inquiry" on your credit report, especially for larger loans like a mortgage. Hard inquiries can cause a slight, temporary dip in your credit score. However, multiple inquiries for the same type of loan within a short period (typically 14-45 days) are often treated as a single inquiry by credit scoring models.

Why do lenders perform affordability checks?

Lenders perform affordability checks primarily to assess the repayment capacity of a borrower. This process helps them mitigate credit risk by ensuring that the borrower can realistically meet their repayment obligations, reducing the likelihood of default. It also aligns with regulatory requirements in many jurisdictions, which aim to promote responsible lending practices and protect consumers from taking on unsustainable debt.