If you’re thinking of taking out a loan – whether it’s a personal loan or secured – how much you can afford to borrow is one of the key questions to ask yourself.
It’s also something the lender will be considering.
Let’s take a closer look at how what you can afford to borrow is worked out by lenders and by you.
From the lender’s perspective:
A secured loan is – as the name suggests – secured against your home, which is why it’s also referred to as a homeowner loan. Because of this security, you can typically borrow more with this sort of loan than you can with an unsecured loan. However, if you don’t keep up with your repayments your home will be at risk.
One of the ways the lender will work out how much to lend you is by comparing the size of your outstanding mortgage and the current value of your home – which is known as the loan-to-value. For example, if your home is worth £200,000 and you owe £150,000 on your mortgage, your loan-to-value is 75%. If you owe £50,000, your loan-to-value is 25%.
The smaller your loan-to-value, the more likely it is that you’ll get a secured loan with a competitive rate. Lenders don’t want you to borrow more than you can afford because it could mean you’re left over-burdened with debt repayments you can’t keep on top of. So, if you still owe a lot on your mortgage and only a small percentage of your home’s equity, a lender will probably shy away from letting you take out a large secured loan.
A personal loan is not secured against your home, but your lender will still look at your finances and work out what they think you can afford to borrow when you apply to them. One of the ways they determine this is by taking a look at your credit history.
This is a record of your borrowing that dates back six years. It lists all the lines of credit you have available to you and the payments you make towards these. If a lender decides that you have access to quite a few lines of credit already, they may decide that if they lend to you too, you wouldn’t be able to afford the repayments – which is why it’s worth closing any accounts you no longer use.
And if you have made any of your repayments late or missed them altogether, a lender will be able to see that too. Missing repayments can act as a warning sign to lenders that you have struggled with credit in the past. You can find out more about your credit history here.
All of this information helps personal loan providers work out how much you can afford to borrow. They will also use it to decide what interest rate to offer you.
From the borrower’s perspective:
However, it’s not only the lender who needs to consider how much you can afford to borrow, but also you. Borrow too much and you could over-stretch yourself and struggle to pay it back.
When you come to take out a loan, don’t just apply for the maximum amount available. Chances are you have a particular project or purchase in mind that you need the money for – like a home extension – so you should just apply for the money you need for that, and no more. While it might seem a good idea to take out some extra, it will increase the time it takes to pay the money back. This means it will take you longer to pay back the loan and could mean you end up paying more interest than you needed to.
As well as thinking about the cost of the project, you also need to work out how much you can actually afford to repay each month. Look at your current budget – how much you have coming in each month and how much goes out towards your regular spending commitments – and work out how much you can afford to put towards your new loan. And keep in mind that you don’t want all of your leftover cash to be used up paying off the loan every month, so make sure you’ll have some free to spend on leisure activities.
Once you’ve worked out your budget, you should have a good idea how much you can afford to borrow. Hopefully this will be enough to fund the project you have in mind, and if it isn’t it might be worth waiting a little longer and saving rather than applying for the loan anyway. If you did, you run the risk that your application will be turned down if the lender doesn’t think you can afford the repayments, or that your finances will be stretched too far once you do start repaying it.
Disclaimer: All information and links are correct at the time of publishing.