Can you afford the loan you are applying for?

The latest credit crunch and mortgage crisis is the best proof for how wrong the assumption that if a lender approves a loan it means that the borrower can really afford the loan and pay it back in full including all interest and other payments. For many reasons bank and lenders approve borrowers that are not really loan worthy for the loan they are applying for. The reason vary from greed to simply making mistakes or using wrong judgments or tools. As much as lenders try they can not know the borrower as well as the borrower knows himself. Some loans are approved because of lack of such intimate knowledge and because further diligent by the lender is too expensive making taking the risk of lending the money more economical than actually applying more diligence.

Our first suggestion is to sit down and try to estimate if you can afford a loan that you are applying for before receiving the reply from the lenders or better before applying at all. There are two main reasons for that. First if your diligence proves that you can not afford the loan then applying for it is simply a waste of time not to mention the implications to your credit report as any application will involve credit report checks which having to many of can decrease your credit history score.

The second reason is more psychological. If you get approved by a lender and then sit down to check if you can afford the loan you might end up not being honest to yourself of cut corners since the approval might be a good enough justification for you to go ahead with the loan. This is not intentional but just the wait we tend to behave. To prevent that possibility it is best that you first make your decision as to the loan affordability before a third party lender pushes you to the wrong conclusion.

So how can you tell if a loan is affordable by you or not? To make a complete financial accurate assessment would take a long time. It is best to focus on some simple rules and considerations. For example estimate the monthly payment on the loan and compare it to the residual income that is available now. It is not enough for the payment to be less than the current residual income. You should try to write down a list of bad things that can happen and see if in those cases you have a way out from the loan or enough slack to continue making payments until the bad things are remedies.

For example you should have enough savings to pay for at least 6 months of payments in case you lost your job with the assumption that in 6 months you should be able to find a new job. You should make sure that after making payments you will still have some residual income to continue saving and for unexpected expenses. Another consideration is the total amount of the loan and the collateral that you take against it. Never risk your life savings or 401K or other pension tools to borrow money. Borrowing to buy a home or a car should use the home or the car as collateral. Taking a loan to buy luxury or leisure products should never be done against savings or other money that is for use in the future.