We get several queries from readers about if they can get a loan or how much loan will they get. Some queries have details about the income or security too. It is not easy to answer such queries. The banks look at many more things before they sign off your loan application. By the way, one sure shot way to find this is to apply for loan with the bank. I understand this is a time consuming and sometimes expensive process. What do you do then? Well, you can step into the shoes of the bankers and think the way banks think when they process a loan application. If you can make an objective assessment (from the point of view of the banks), you will have good idea if your loan application is strong.
In this post, let’s understand some of the potential areas that the bank will consider before signing off your loan application.
#1 The Bank Looks at Your Repayment Ability
After all, you need to repay the loan. And the banks want you to repay the loan. For that, you need to have requisite income to support such repayments. Unless you happen to be an influential corporate borrower or the bank wants to clear its own mess, the bank won’t lend you more than you can repay. There is concept of Fixed Obligations to Income Ratio (FOIR).
What is FIOR?
I have gone through this concept in many of my earlier posts. However, I will still touch upon the concept briefly. Your fixed obligations are your loan EMI payments. A bank will give you only so much loan so that your monthly loan obligations (for all the existing loans and the proposed loan) do not exceed a certain threshold (FOIR). This threshold (FOIR) is expressed as a percentage of your net monthly income. Every bank will have its own threshold.
So, if your income is Rs 50,000, you have no other loans and FOIR is 50%, the bank will not give you a loan that your EMI breaches Rs 25,000 per month. Now that you know the maximum EMI, the loan interest rate and the loan tenure, you can easily calculate the maximum loan amount by using Excel PV function. Alternatively, you can feed these numbers in our loan calculator to arrive at the maximum loan amount.
By the way, the rationale behind having FOIR is that you just don’t have to pay your loan EMI from your monthly income. There are many other expenses to take off. You can pay the EMI only from the amount that is left after taking care of these essential expenses.
For a detailed discussion on loan eligibility, you can go through this post. In fact, there are loan products that have been structured to take care of this very issue. There are step-up loan products that increase your loan eligibility.
#2 The Bank Looks at the Stability of Income
You know that salaried employees find it easier to get a loan as compared to self-employed or professionals. The cash flows for non-salaried are not as consistent. For this reason, the bank can impose more restrictive eligibility conditions for non-salaried applicants.
#3 The Bank Looks at the Collateral
The interest rate for unsecured loans is typically higher than secured loans. Think of credit card debt and personal loans. In case of unsecured loans, there is no security to bank on if the borrower does not pay. The bank can take coercive action against the borrower, but it may not yield much. For this reason, when it comes to credit card and personal loans, the repayment ability or the income becomes a very important factor. Since the bank is taking a greater risk, the interest rate is higher.
#4 The Quality of the Security (Collateral) Matters Too
From the point of view of the bank, it is better if that security is liquid and easily enforceable. The reason is if you can’t make the payments on time, the bank can simply sell off your security and set off the loan. In fact, if the security is liquid and easily enforceable, the bank may not even look at your repayment ability. Classic examples are gold loans, loan against shares or mutual fund units.
On the other hand, if we are talking about a home loan or a property loan, even though the bank can foreclose the property and recover the loan amount, the legal process can be long. The borrower can scuttle the recovery process. All this while, the unpaid interest keeps increasing the outstanding loan amount. Moreover, the security per se may have issues. What if the loan was taken for an under-construction property or the developer has not delivered? In a way, there is not much to sell. Hence, in case of home loan or loan against property, the banks focus a lot of your repayment ability.
Liquidity is not the only aspect. The banks will find a property in a familiar or prominent locality more reliable than a property in an obscure location.
#5 The Value of the Security Shouldn’t Be Too Volatile
If the value of the security is too volatile, then the quantum of the loan as compared to value of the security is likely to be low. In banking parlance, this ratio is referred to as Loan-to-Value (LTV). For instance, the LTV for equity mutual funds units is capped at 50%. The loan against debt fund units is much higher (banks can choose as per Board approved policy). The reason is the market value of equity fund units is much more volatile than debt fund units. The market value of equity fund units or equity shares can deplete very quickly leaving lenders uncomfortable. More so because repayment ability of applicants was never considered while giving out loans. In such cases, the bank asks borrowers to either repay part of the loan or furnish more security.
When it comes to LTV, RBI also imposes restrictions in many cases. For instance, RBI has LTV caps of 50% on loans against equity MF units and 75% for gold loans. By the way, these are the maximum LTVs. The bank policy may prescribe much lower LTVs. On the other hand, the market value of the property is not considered as volatile. Therefore, you can get a higher LTV for home loans (subject to bank policy).
#6 The Banks Look at Your Credit Behaviour Too
How can they ignore this? Habits die hard. Repayment ability is important only if you plan to repay the loan. If you have been a responsible borrower in the past and have made payments on time, it is likely you will continue doing the same in the future. If have not been responsible with credit in the past, the banks won’t trust you as much. Your credit behaviour is reflected in your credit score and credit report. Therefore, the banks look at that too.
Conclusion
In my opinion, the aforesaid points are all that matter to a bank. Do point out if I have missed out on something. Remember, when the bank is not satisfied with your repayment ability or the collateral offered
- It can decline to give you the loan OR
- It may not give you much loan as you would want OR
- It can ask you to furnish more security OR
- It will give you the loan at a higher rate of interest
There are certain avenues of borrowing where lender may not focus much on either your repayment ability or the security. A case in point in P2P lending platforms that offer you unsecured loans. Well, do consider the interest rate you have to pay there. In addition, there are certain types of loans that may be given as part of Government schemes (Mudra Yojana) or under priority sector lending. Then, there are student loans that may be given without any security or repayment ability simply based on income potential of the borrower. Well, these are exceptions.