Have you thought about taking out a loan lately? Then you might have heard the term “debt servicing”. But what does it really mean, and why should you care about it?
Let’s start from the beginning…
What is it?
In the broadest terms, “debt servicing” refers to your ability to repay a loan with the amount of money you earn.
Your “debt servicing ratio” is usually presented as a percentage. It’s calculated by adding together all the repayments you have to make in a month, on everything you owe, and then working out what proportion of your income that debt repayment represents.
Why is it important?
Debt servicing is one of the key things that lenders consider when assessing your loan application. It allows them to see whether there is enough money coming in each month to cover all your obligations, and that there’s room to move a bit, should anything change.
It all sounds pretty straightforward. But if you take a closer look at what debt servicing is, you’ll find that there’s a little more to it than just a black-and-white percentage or a calculation of income vs outgoings…
It considers the different scenarios
In an effort to promote responsible lending, debt servicing has become increasingly complex and important in recent years, helping lenders make sure that borrowers are in the right financial position to apply for a loan and pay it off.
While you might be able to show that you have space in your budget for a certain level of loan repayment, a debt servicing test will look a bit deeper. It will assess how likely you will be to continue to make those payments if things changed, and look at whether you’re able to service the loan without putting yourself into hardship.
It’s about your financial wellbeing
In a nutshell, debt servicing calculations are an important part of making sure that your new loan fits into your budget and helps you move towards your financial goals. They don’t simply look at how low your current spending is, but also whether there is room in your budget for extra spending.
- If interest rates rose, could you afford to pay a bigger payment?
- Would you be able to meet your commitments if you were out of work for a short period, or between jobs for a while?
- What other obligations may arise for you, e.g. new credit card debt?
Taking steps to improve your debt servicing capability
Different lenders have different ways of calculating your ability to service your debt, but a responsible lender will always check to ensure that you are able to service the loan comfortably.
So before you apply, it’s important to make sure that your financial situation is in good order. For example, are there any debts you can pay off in a short period of time? How many credit cards do you have – and how many do you need?
Even if all your credit cards are paid off in full, the lender may still consider the available balance and how you’d cope if you ran all your cards up to the maximum. That’s why it’s often recommended that people close unused credit cards before they apply for new loans.
Like to discuss your options?
If you are looking for a car loan to buy your next set of wheels, and would like to learn more about your options, please get in touch. Debt servicing is just one of the key factors that lenders take into account, so it’s a good idea to have a clear understanding of your finances before applying.
Call the team at AA Finance on 0800 500 555, seven days a week between 9 am and 5 pm. We’re here to help.
Disclaimer: Please note that the content provided in this article is intended as an overview and as general information only. While care is taken to ensure the content is correct, the information provided is subject to continuous change. Please use your discretion and seek independent guidance before making any decisions based on the information provided in this article.