This is how a bank lends money to YOU

Have you ever wondered how a bank decides how much amount to lend to you?

Ever wondered why there is a different cap on different loans?

Credit appraisal is the step which decides everything. Credit appraisal is the process by which a lender appraises the creditworthiness of the prospective borrower. It is a very important step in determining the eligibility of a loan borrower for a loan. Every potential borrower has to go through the various stages of a credit appraisal process of the bank, which might include an interview with the bank officials.

However, just like every bank charges different rates for different loans from different customers, in the same way, each bank has its own set criteria that a borrower must satisfy to qualify as a certified borrower of money/assets from the bank. All banks have their own rules to decide the credit worthiness of their borrowers.

As has been mentioned, the eligibility of a borrower for a loan depends on her/his creditworthiness, however, how is that determined?

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Creditworthiness of a customer lies in assessing if that customer is reliable to repay the loan amount in the stipulated time, or not. Here also, every bank has their own methodology to determine if a borrower is creditworthy or not.

It is determined in terms of the norms and standards set by the banks. Being a very crucial step in the sanctioning of a loan, the borrower needs to be very careful in planning her/his financing modes. However, the borrower alone doesn't have to do all the hard work.

The banks need to be cautious, lest they end up increasing their risk exposure. All banks employ their own unique objective, subjective, financial and non-financial techniques to evaluate the creditworthiness of their customers.

While assessing a customer, the bank needs to know the following information: Incomes of applicants and co-applicants, age of applicants, educational qualifications, profession, experience, additional sources of income, past loan record, family history, employer/business, security of tenure, tax history, assets of applicants and their financing pattern, recurring liabilities, other present and future liabilities and investments (if any).

Out of these, the incomes of applicants are the most important criteria to understand and calculate the credit worthiness of the applicants.

As stated earlier, the actual norms decided by banks differ greatly. Each has certain norms within which the customer needs to fit in to be eligible for a loan.

Based on these parameters, the maximum amount of loan that the bank can sanction and the customer is eligible for is worked out. The broad tools to determine eligibility remain the same for all banks.

1. Installment to income ratio

This ratio is generally expressed as a per centage. This per centage denotes the portion of the customer's monthly installment on the home loan taken. Usually, banks use 33.33 per cent to 40 per cent ratio.

This is because it is has been observed that under normal circumstances, a person can pay an installment upto 33.33 to 40 per cent of her/his salary towards a loan.

For example, if we consider the installment to income ratio equal to 33.33 per cent, and assume the gross income to be Rs 30,000 per month, then as per the ratio, the applicant is eligible for a loan with the maximum installment of Rs 10,000 per month.

2. Fixed obligation to income ratio

This ratio signifies the importance of the regularity in the repayment of previous loans.

In this calculation, the bank considers the installments of all other loans already availed of by the customer and still due, including the home loan applied for.

In other words, this ratio includes all the fixed obligations that the borrower is supposed to pay regularly on a monthly basis to any bank. Statutory deductions from salary like provident fund, professional tax and deductions for investment like insurance premium, recurring deposit etc. are exempt from these fixed obligations.

As an example, assume that monthly income of an applicant is Rs 30,000 and the applicant has a car loan installment of Rs 4,000 per month, a TV loan installment of Rs 1,000 per month.

In addition to this her/his proposed housing loan installment is Rs 10,000 per month. Numerically, the ratio is equal to Rs 15,000 or 50 per cent (i.e. 50 per cent of the monthly income). If the bank has decided on the standard of 40 per cent of ratio as the criteria, then the maximum total installments the person can pay, as per the standard, would be Rs 12,000 per month.

As s/he is already paying Rs 5,000 for the car and TV, s/he only has Rs 7,000 left out.

Hence, the customer would be given only that loan for which the EMI would be equal to Rs 7,000, keeping in mind the repayment capacity of the applicant.

3. Loan to cost ratio

This ratio is used by banks to calculate the loan amount that an applicant is eligible to pay on the basis of the total cost of the property. This ratio sets the upper limit or the maximum loan amount that a person is eligible for, irrespective of the loan eligibility under any other criteria.

The maximum amount of loan the borrower is eligible to pay is pegged as equal to the cost or value of the property. Even if the banks' calculations of eligibility, according to the above mentioned two criterions, turns out to be higher, the loan amount can't exceed the cost or value of the property.

This ratio is set equal to between 70 to 90 per cent of the registered value of the property.

Hence, while deciding on the maximum amount of loan a customer can be given, the banks use these three parameters. These parameters help in computing loan eligibility, which is crucial in calculating the creditworthiness of a customer. It also acts as a guide to determine the loan amount.

However, if all the three ratios yield a different value, which is commonly the case, what do the banks do?

Simple, they generally select the lowest of the three as the loan amount that the applicant is eligible to pay.