What is Ability to Pay?
Ability to pay refers to a borrower’s capacity to make good on his loan obligations. In banking, ability to pay is often called “financial capacity.”
How Does Ability to Pay Work?
When considering a loan, a banker will first and foremost consider the borrower’s ability to pay, which can be viewed as the financial capacity of the borrower to service his existing debts. Financial capacity can be demonstrated by an employment history that shows a steady stream of earnings, an investment that produces a steady stream of income, or a pool of highly liquid and available assets that can be liquidated as needed.
Why Does Ability to Pay Matter?
Banks and other lenders evaluate an individual's ability to pay when considering a loan application. An individual whom a lender deems as having a greater ability to pay will be considered a better, less risky loan candidate than someone with a lower ability to pay.
Lenders theoretically use the five C’s of credit to evaluate the quality of the loan application: 1) Character of the borrower, 2) Capital, preferably stable and liquid, 3) Capacity to generate cash flow through employment, investments, etc., 4) Collateral, and 5) Conditions, economic or otherwise.
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