Whether you are borrowing a short term loan or a long-term loan, the criteria for deciding how much you should borrow is almost the same. It’s important to follow the criteria lenders use since they ultimately decide how much you can borrow. One of the most important factors lenders consider (and you should consider too) is affordability. To calculate affordability, you need to consider your income and factors such as debt expenses and the size of your down payment (if applicable). Below is a discussion on how to decide the amount of money you should borrow.
What is your debt-to-income ratio?
Your debt-to-income ratio is the percentage of your income you spend on repaying debts like credit card payments, an auto loan, student loan, mortgage, etc. Your debt-to-income ratio shows how much money you spend monthly repaying your debts. If you earn £6,000 every month and pay debts amounting to £2,000 every month, your debt-to-income ratio is 0.33 (33%).
Lenders have different requirements depending on the type of loan you want. For long term loans, most lenders require all your debt commitments to be 0.36 or 36% or less. The ratio can, however, vary from one lender to another depending on type of loan, term of the loan etc. Short term loans like payday loans have more flexible debt-to-income ratio requirements because they involve small amounts paid over a short period.
If you earn £6,000 for instance and you have existing debt commitments amounting to £1,000, you shouldn’t borrow more than £1,160 so that your debt-to-income ratio is 36% or less. In this example, your total debt will be £2,160 against an income of £6,000 which is within the recommended (0.36 or 36%) threshold. It is also important to note that you don’t have to borrow more than you need. The debt-to-income ratio helps borrowers determine the most affordable loan amount.
What is your credit history?
Lenders also consider a borrower’s credit history when deciding what they should lend their customers. If you have a good credit history, you will be able to borrow more than usual at a lower interest rate. This shouldn’t, however, be taken to mean that you should borrow more than you need. A good credit history will simply give you leeway if you want to borrow more. If you can afford a bigger loan comfortably, you can use your good credit history to your advantage otherwise, don’t take a loan you can’t afford even if your credit history is good (700 or higher).
How much do you need?
Your debt-to-income ratio should give you a rough idea of how much money you can afford to borrow comfortably. Your needs should help you come up with an exact figure. Using our above example, if you can borrow £1,160 comfortably, but you need a £500 loan, don’t borrow more than what you need. Loans especially short term loans like payday loans should be used to cater for unavoidable expenses, not luxuries. Unless you are planning on investing the additional amount, stick to what you need to avoid servicing unnecessary expenditure.
Do you have a down payment?
You should consider down payment when you are taking long term loans like a mortgage. A large down payment allows you to borrow more and vice versa. It’s always better to pay more substantial down payment because you also reduce your repayments and get better interest rate deals compared to someone who pays the minimum down payment. If you don’t have a large down payment, borrow modestly because you have little leverage to negotiate better terms.
Consider lifestyle factors
Your lifestyle should also come into consideration when you are deciding how much you should borrow. Although the debt-to-income ratio is a perfect place to start, you need to consider how the new loan will affect your lifestyle. For instance, when taking up a mortgage to buy a house in a city with poor public transport, you might have to factor in additional transport costs. You might also need to spend additional money moving your children to nearby schools. Lenders don’t account for such factors, so it’s important to consider them yourself. Considering lifestyle factors helps you determine with certainty how much you should borrow and if it is affordable.
There are a lot of factors you need to consider when you are deciding how much you should borrow. The most important factors revolve around affordability. You should never take up a loan you can’t afford to pay comfortably. Luckily, the above factors are adequate to help you do just that.