Capacity

Last month we discussed the first “C” of credit – Character – that you need to know about in order to significantly enhance your loan application and increase the likelihood of getting the “nod of approval” from your lender. This month I want to walk you through the second “C”, which is Capacity. This is a relatively simple one because it is about the applicant’s ability to service a loan. So what do lenders really look for when they check out your serviceability?

The first point that you need to understand when it comes to Capacity, is that a lender is really only interested in your historical income not your potential future income. This is not to say they won’t take your earning capacity of tomorrow into account, but what they want to see is what you “have” made not what you “might” make. This is only logical as any prediction of future income is only speculative and cannot be relied upon as set in stone.

This is why they like to see two of your most recent consecutive payslips or your last two years of business financials (if self employed); they represent historical documentation and are relatively indicative of what type of income you, the applicant, will make going forward.

Future income (like rent from the newly purchased property) can be taken into account, but it is often discounted to around 75 to 80% of the projected value to allow for variations like vacancies and running repairs, etc.

It’s important to note that if you go for a loan on the basis that you are starting work on Monday after a 12 month period of unemployment, you will struggle to get the application over the line. Conversely, if you are transferring to a new job in the same industry on Monday after working for 3 years in your previous capacity, your application will be looked upon quite favourably. The point I am trying to make is how your history will tell the lender a story about your capacity to repay the loan.

Capacity is all about you proving to the bank that your historical income has the ability to service the new loan. It is about you, the applicant, demonstrating that you have the financial capacity to service the debt without hardship.

Let’s expand on this further and look at some different employment types to see what a credit assessor will be looking for as evidence of capacity to service a new loan in various personal circumstances.

When assessing capacity, the credit analyst will be looking to see where your income is derived from and what expenses you will have, which of course will leave a surplus to service the new loan you’re applying for.

So where is the income derived from?

Is the applicant;

A casual employee
A contract employee
Salary / Wage earner
Self employed
Commission based employee
Part Time employee

What expenses is the applicant going to incur?

Existing home, Investment, car, and credit card loans
Is there a Spouse and children to support?
How much is the new loan applied for?

When it comes to capacity, credit assessors are naturally conservative; they will always err on the side of caution, so let’s take a look at each form of income stream and dissect what a credit officer is looking for.

Casual employee

The difficulty with being casually employed is that while you have a job today, you might not have one tomorrow – to a lender, it’s simply as black and white as that. And because your income stream can stop as suddenly as that, the credit assessor is typically going to say no. But not in all cases…if it can be confirmed that the borrower has been in the industry in which they are casually employed for 2 to 3 years or more and they are able to provide say 2 years of tax returns, the lender can then average out the income from those returns and rest on that. Unfortunately most casual jobs are casual for a reason and generally aren’t reliable enough sources of income for servicing loans.

Contract employee

These days more and more people are electing to enter into contracts with their employers as it often means a higher rate of pay, negotiated terms and a set time frame to complete a project. When assessing a PAYG contractor, lenders are interested not only in evidence of the income but sighting the contract and reviewing its length and terms.

Character plays a role here too because the lender wants to know how long the contractor has been in the industry, as well as the likelihood of contract renewal. They will often contact the contract provider and ask various questions about this. If the contract is short and there have been many different contracts over the last 2 to 3 years with different companies, then a credit assessor will typically request tax returns and again average out the income from those.

Generally speaking though, this form of income is as reliable as full time employment.

Salary or Wage earner (also known as Pay As You Go – PAYG)

The most common from of income is generated from Salary or Wages and is typically referred to as PAYG. For a credit assessor, this form of employment and earnings is easy to assess and they will generally ask to cite 2 consecutive payslips as evidence. The payslips should include the following, which will be carefully assessed by the lender;

Name of employer and ABN (cross checked for authenticity)
Name of employee – matching the borrower
Weekly / Fortnightly Gross income
Any allowances like uniform or acting up
Overtime
Year to Date Earnings matching the weekly income

From this they will calculate annual earnings, taking into account income tax and the Medicare levy and apply the net to their servicing model for the proposed new loan. PAYG income is one of the easiest income streams to work with because it is all laid out in black and white in a single payslip.

Self employed

This is possibly the most complex income to verify for a credit assessor, primarily because the Profit of a business can be manipulated by the owner or accountant.

In this instance, a credit assessor will request two different sets of documents; signed Tax returns and the financial statements that made up the Tax returns.

These tell a story of how the business is travelling financially from a management point of view. They contain opening and closing balance sheets, which is the business’s Statement of Position at the beginning and end of the Financial Year and the Profit and loss, which outlines income and expenses.

Within these statements, the credit assessor is looking for irregularities like non recurring income or expenses. They also perform acid tests on the business financials for solvency and liquidity and benchmark against industry standards.

Because a business can do well one year and not so well the next, banks will usually ask to see two years of returns, they will then average out the income over the two years and use this figure for servicing. Some lenders even go to the extent of requesting 3 years to provide a clearer picture.

Being self employed has it perks, but applying for a loan isn’t one of them.

As always though, necessity is the mother of invention and this is how Self Certified income loans came about; they were designed for the business owner to “self declare” their income with less supporting paperwork. They are also known as Low Documentation loans, and became very popular with property investors looking to hold more property than their payslip would support. However since they were abused, they’ve now had credit policy tightened around them. They are still available for the business owner, but require Business Activity Statements to accompany the application. The idea behind the Low Doc loan was that if the business owner contributed a higher amount of capital (deposit) the bank would OK the loan, but with a higher interest rate to reflect the extra risk involved.

Commission based

Commission based wages are also becoming a more common form of earnings amongst Australian employees these days, particularly in the arena of sales jobs like car sales and of course, real estate. If your primary income is in the form of commission, that is a percentage rate payable on performance, typically lenders will want to see two years worth of earnings evidence such as income statements and/or tax returns.

Based on that paperwork, they will average out your earnings and establish your lending capacity using 100% of the average. If you have been employed in a commission earnings position for less than 2 years, they can discount your average income by 50% to 100%. The point to be noted here is that the lender is essentially looking for evidence of consistent income across the board. They need to reassure themselves that you can make your repayments month to month, without any dry spells of low or no commission payments.

Part Time

Part time employment is treated exactly the same as full time employment, in that as a PAYG salary or wage earner, they will ask to cite evidence of your income and from there, calculate your annual earnings to determine your lending capacity.

Make it official

When considering the documentation you will need to provide with your loan application in order for the lender to assess your lending capacity, it should be noted that a credit assessor will look more favourably upon financial statements and tax returns prepared by practicing accountants. That is because they are nicely laid out and easy to follow, as many accountants use the same software.

Financial statements presented as excel spreadsheets and handwritten tax returns prepared by the borrowers themselves are generally difficult to read and regularly questioned for authenticity. Once a credit assessor begins questioning authenticity, they will scrutinise every little bit of documentation you present to them, so for the sake of a few dollars in service fees it is far better to have a professional complete your annual returns.

Based on these financial documents, the credit assessor will plug all relevant numbers into a spreadsheet and rate your lending capacity on the back of how you derive your income, what it equates to on an annual basis and how much cash you have left over after expenses are accounted for.

Essentially, the credit assessor needs to establish how the loan is going to be repaid and importantly, whether the applicant can continue to make repayments in a high interest rate environment. This is why assessors increase the interest rate on the loan applied for as well as on the current facilities held by the borrower, and is a practice known in the industry as “stressing” the loans or “applying a stressed interest rate” to existing loans. The lender has to be reassured that as a borrower, you can cover all repayments over the life of the loan. Typically when making these calculations, an assessor will add 2% to the current variable rate and calculate all repayments on Principal and Interest over a 25 year period.

Of course many loan applicants have distinct and individual circumstances that may not fit neatly into any of the earnings compartments summarised above. So let’s work though a couple of different scenarios to get a handle on how lenders assess capacity when the applicant’s income is not so black and white.

Future earnings

Some people will need to make a loan application based on future earnings. For instance you might be in the process of acquiring a Subway franchise and you’ve never been a franchisee running your own business before; you’ve worked as a public servant for the last five years. So what happens if the cashflow is futuristic, as in this example? In this instance, the lender will have benchmark figures in place from other franchise stores, so they use these historical figures to determine the future cashflow. Often you will find with major franchises that a large bank will finance them because they have done a number of them in the past. There is often extra risk associated with this type of lending so the interest rate and loan to value ratio are adjusted to match that risk.

On the other hand, if it is a start up business with no track record then providing evidence of capacity is rather difficult.

No evidence of capacity

What happens if you cannot provide evidence of capacity at all? Let’s say your business financials are not up to date or you are a seasonal worker and it’s the off-season? Well there are loan products out there to cater for individuals who find themselves in these circumstances, however they do come with different conditions and require the applicant to contribute a larger deposit.

The bottom line when lenders assess your borrowing capacity is that higher risk loans will usually result in a higher interest rate charged, so if you cannot provide evidence of capacity and can reduce the funding ratio with extra cash then you may be able to secure an asset lend, where you are borrowing against the asset in question at say 50 or 60%, and the lender thereby takes a managed risk.

Overall, there is an array of ways to ascertain whether one can afford the new borrowings they are applying for and the lender has many alternatives to simply assessing your income when determining your lending capacity, including things like Debt Servicing Ratio’s and Interest Time Cover. The take home message for anyone applying for a loan is to have all of your “i’s” dotted and “t’s” crossed when it comes to the paperwork you provide the credit assessor as the easier it is for them to calculate your borrowing capacity, the easier it will be for you to get the nod of approval. <–>

This entry was posted on Thursday, September 3rd, 2009 at 17:19 and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.