If you have ever lent money to a friend, you know that it holds a certain amount of risk of whether or not you will ever get it back. In a similar but much larger scale, banks lend to borrowers and the risk they hold is much higher as lending is a major part of their business.
Additionally, the money that banks lend is usually funded from the deposits they get their customers and as a legally registered institution, they are liable to safeguard this money and give it back to customers with promised returns.
When bad debts mount, the bank's non-performing assets will increase and hurt their business. With such high stakes comes the need to follow a sophisticated formula to calculate the risk of lending to a particular applicant, be it an individual or a business and mainly determine if they will be able to repay the loan.
Ratios used by lenders
An individual's PAN holds the record of all their earnings and expenses. Banks or financial institutions look into credit history, asset details, income earning capacity, current liabilities, age, education, tax payment history, and other data to calculate one's loan eligibility.
The most popular of the ratios used to compute these include FOIR and LTV.
What is FOIR?
FOIR or Fixed-Obligations-to-Income-Ratio as the full form suggests is a measure of person or business' fixed debt obligation as a ratio to the income they make.
Also known as debt-to-income ratio, it is commonly used by a lender as one of the many parameters to decide the loan eligibility of the applicant.
This FOIR is a percentage limit that can vary collectively based on the type of loan, applicant's distinct characteristics, etc. The ratio accounts for the monthly "fixed obligations" that the applicant has to meet on a monthly basis.
The idea is to calculate how much disposable income the borrower has after making fixed expenditures.
So, if the individual's salary is Rs 50,000 (in-hand) and the lender calculates his/her FOIR as 50%, it will mean that he/she can pay rent, existing loans bills and other living expenses with Rs 25,000 (50%) and the can borrow a loan with an EMI that come to a maximum of remaining Rs 25,000 only.
These fixed obligations would include debt payments that are made every month and are fixed in nature. For example, EMI of a home loan already taken or a fixed credit card payment.
Statutory payments deducted by the employer or bank towards provident fund, insurance recurring deposits or professional tax do not form a part of this.
For individuals, only debt obligations made from their savings account is taken into account by the lender.
FOIR= Total obligations (ie. debt and living expenses) /net monthly salary
Mr. XYZ earns Rs 75,000 (in-hand after statutory deductions) per month and his monthly expenditure considering the residential location, age etc is Rs 25,000 and he pays an EMI of Rs 5,000 towards a car loan.
The lender will calculate his FOIR to be 40 percent, wherein his monthly EMI for a prospective loan can go up to Rs 40,000 per month, which is rest of the 60 percent of the salary.
A customer like Mr. XYZ with low FOIR or low debt burden is desirable to the bank as he has more disposable income to take a bigger loan. Such customers are also lured with competitive interest rates.
An applicant with higher FOIR is offered a smaller loan amount due to the smaller EMI limit and greater risk of default in payment.
FOIR calculations vary based on lender and customers. Some lenders offer FOIR as high at 60 percent to highly qualified and high earning individuals like doctors.
Usually, FOIR is set between 40 to 55 percent and could reduce or increase based on individual cases.
It also varies based on the type of loan. If it is unsecured, the FOIR criteria will be stricter than that of a secured loan. Government sponsored loan schemes will have a lenient criterion.
What is LTV ratio?
LTV or Loan-to-Value is another measure used by the lender to assess risk and qualify the loan eligibility. It is the ratio of the loan amount against the value of the asset.
LTV= Loan amount/ appraised value of the asset.
- Individual: Suppose Mr. ABC wishes to purchase a house worth Rs 40 lakh with a borrowed amount of Rs 35 lakh, the loan-to-value ratio would be Rs 30,00,000/Rs 40,00,000 = 75%. The rest of the amount to be paid to make the purchase will have to be from Mr. ABC's own income.
- Businesses: ABC Inc wishes to acquire a building worth Rs 40 lakh and decides to opt for a Rs 30 lakh loan. With the same LTV percentage above, 75 percent is raised through a loan (debt) and the remaining Rs 10 lakh will have to be met through equity.
Here, the higher the LTV ratio, the riskier the loan to a lender. The value of the asset considered by the bank is determined typically by a third-party appraiser and is known as "appraised value".
How can a customer reduce his/her LTV?
Appraised value (market value of the asset), sale price (the price at which one buys the asset) and the down payment decide the LTV.
One can increase the down payment to reduce the LTV and improve their chances of getting the loan approved.
For example, the borrower is looking to buy a house whose appraisal value is Rs 50 lakh and the seller is willing to make the sale at Rs 40 lakh.
With a down payment of Rs 5 lakh, the borrower can now bring down the loan amount to Rs 35 lakh, which would bring the LTV to 70 percent.
FOIR + LTV, the Double Whammy
The loan amount (LTV) that the borrower is looking to get and the amount that the bank is willing to risk by lending to the said borrower is decided in a combination of FOIR and LTV.
Considering the previous example where the borrower wants a Rs 35 lakh home loan for say a period of 20 years, the EMI would come to Rs 14,584 per month.
Whether or not, the borrower has the appetite to pay this amount every month for the next 20 years along with the interest (which is an additional burden) will be decided on the basis of FOIR.