How do banks decide what you can afford?

Today we’re going to take a quick look at debt-servicing.

Debt servicing is a fancy way of saying ‘affordability’. Affordability is a key part of the approval process for banks. Oftentimes, debt servicing is the reason for an application getting approved or declined.

Your debt-service ratio takes into account all your current obligations and displays them as a percentage 

of your total gross income. The banks then have certain levels of this ratio that they are willing to tolerate depending on the details of the loan you’re requesting.

In auto financing most banks use between 40 – 42% debt-servicing as the maximum they will allow including the new payment you are looking for. They do their calculations using monthly figures because that’s how most financial products are structured.

There are multiple types of debts the banks look at to determine your debt-service ratio. They look at revolving credit, installment payments, and other expenses (some of which are mandatory, like insurance).

Revolving credit accounts are things like credit cards and lines of credit. These are accounts that you can borrow from and pay back at any time. The balance fluctuates depending how much you want or need to use it.

These are the most common type of debts. Most young people are able to get a credit card before a loan as a way to start building a credit file and history.

Installment payments are any accounts where you make a fixed payment at a regular interval. The car loan you’re applying for is considered an installment payment. Other examples include mortgages and personal loans. You pay the same amount each stated time period. It’s important to note that a rent payment is viewed the same as a mortgage payment when calculating affordability.

Other expenses that the banks have to account for are things like maintenance and insurance (as your car will undoubtedly need maintenance, and insurance is required by law). Each bank is a little different in the amount they use to account for insurance because insurance prices vary from person to person, but it’s important to know that it is a factor in their calculations.

NOTE: this is a simplified example to illustrate the process.

We’re going to make the following assumptions:

• You earn $40,000 per year gross income
• You have a mortgage (or rent) payment of $650 per month
• You have a credit card with a limit of $10,000
• You have a monthly student loan payment of $250
• The new car you want costs $400 per month.

To calculate your debt service ratio we must first determine the monthly values of each payment. The mortgage and student loan debts are easy because they are already fixed at $650 and $250 per month, respectively.

To calculate the monthly figure for your credit card payment we must calculate 3% of the limit of the account. In our case, that means:

$10,000 (credit card limit) x 3% = $300 per month for this debt payment.

NOTE: It’s important to note that even if you have a $0 balance on your credit card (or line of credit) the banks will still calculate this value. This is because, technically, you could go out tomorrow and max out all of your credit cards and lines of credit, but the bank still needs to ensure that you can make the required loan payment.

Now that we have the monthly values we can calculate the approximate debt-service ratio. We have:

$650 (mortgage or rent) + $300 (credit card payment) + $250 (student loan) = $1,200 per month in current debts.

Now we can add in the new car payment that we’re looking for and we get:

$1,200 (current debts) + $400 (new car payment) = $1,600 per month in debts.

The last thing to calculate is our maximum allowable total of all these payments. Remember, earlier we determined that banks use 40-42% of gross income (depending on the bank) as the maximum.

To calculate this we get:

$40,000 (annual gross income) / 12 = $3,333 monthly gross income.

$3,333 (monthly gross income) x 40% = $1,333 maximum allowable.

This means that with our new car payment our debts are over the maximum allowable at $1,600 per month vs $1,333 per month allowable.

To calculate the actual debt-service ratio we simply divide our debts by our monthly gross income.

In this case we get:

$1,600 (debts including new car payment) / $3,333 (gross income per month) = 48%.

This gets us an approximate value but not an exact one. Remember that the banks have other factors such as maintenance and insurance that they account for, as well.

In the next post we’ll cover cosigners and how they work so that if you’re debt servicing ratio is too high, you could still get approved for the loan you’re looking for.