Posted in Finance, Accounting and Economics Terms, Total Reads: 360
Definition: Ability to Repay
Ability to repay is the financial capability of individual or an institution to repay a debt or a loan. Before offering a loan, lenders have to make a sincere and honest determination that the borrower has a reasonable ability to repay the debt. Financial capability of the borrower can be determined by factors such as the borrower’s employment status, income, credit history, assets, ongoing expenses towards other loan payments, alimony, child support payments etc. Lenders consider that the person who has a greater ability to repay would be a less risky candidate for taking a loan.
Ability to repay rule was included in the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act in the wake of the housing bubble crisis in the USA. In the mid-2000s some of the lenders accepted loan applications with little or no documentation with regards to borrower’s income or his assets. They offered mortgages just by relying on the underlying value of the asset. When the real estate prices started to fall in early 2007, such loans had to be foreclosed resulting in the collapse of the housing bubble.
Example: Mr.A has applied for a mortgage loan with ABC bank for $100,000. He has been working at General Motors for the past 7 years and his salary is $60,000 p.a. The value of the underlying asset is $120,000 and the real estate rates are expected to remain flat for the next 3 years. His has a good FICO score (credit score- USA) and has been paying his dues on time. But a detailed check reveals that Mr.A has an outstanding loan balance for $80,000 secured by the same property. So even though Mr.A has a steady income and an underlying asset of considerable value his ‘Ability to repay’ is low since he has a huge outstanding loan amount secured by the same property.