3 Financial Ratios Lenders Evaluate For Home Loans
Self-employed businessmen and entrepreneurs assume that getting a home loans from banks and financial institutions is easy as a peach. With income statements, lenders cannot ascertain that the same pattern will follow in the future. And because of the same, profit to the businesses is not the only factor that banks look at while evaluating the financial prominence.
To arrive at a clear image of the financial prominence, lenders also look at other key factors involving ratios. For a businessmen or self-employed entrepreneurs, this knowledge about the way in which banks assess and arrive at those ratios is vital. This article elaborates the 3 most important financial ratios that the banks evaluate for Home Loans.
DSCR which expands as Debt Service Coverage Ratio:
For people who run businesses, the banks evaluate the DSCR or Debt Service Coverage Ratio. This ratio identifies the ability of the borrower to repay the loan. With this ratio, the lenders can find out the profit in cash that is available to repay and close the debt along with the interest rate for the principal amount. This ratio is considered the most important by the lenders because it shows the capacity of the loan applicant to repay the loan without any trouble.
Another reason this ratio is vital because it certifies that the applicant will be able to repay the complete debt for the complete loan tenure. This ratio is evaluated by deducting non-cash expenses, profits after tax, monthly instalment along the interests and rentals for lease paid by the business for the current year from the net income shown in the business’s financial statement.
When the DSCR is lesser than one, this shows that the business is inefficient to get profits that would be able to close the debts. If the ratio is more than one, then it shows that the business is efficient to repay the loan and take care of dividends too. With high DSCR, the business seems to promise better debt repaying capacity.
If the DSCR is less than one, this reflects the inability of the firm’s cash profits to serve its debts. If the DSCR is greater than one, this reflects the firm’s ability to service the loan and pay dividends at the same time. Higher the DSCR better is the firm’s debt servicing capacity. Lenders do not evaluate DSCR just to derive a numerical value; they also interpret the value quite seriously. A good DSCR value ranges from 1.5 to 2.0.
If the lenders are still sceptical about the financial strength of the business, they also scrutinize the profit making ability of the firm and the demand of the service/product they provide. This ratio can be slightly bettered by elongating the repayment tenure of the loan.
Ratio of debt to income:
Assuming that having adequate assets as collaterals is enough to get a loan sanctioned is quite narrow minded. Any business has to make enough profit to cover all the expenses for operation and also repay the loan that it owes.
This debt to income ratio determines the quantity of the income that is spent on debts. When this ratio is very high, it shows that the income of the applicant is already being utilized to repay other debts which consequentially prove that there is no chance for another loan. If another loan is taken by the applicant, then he/she might find it really hard to repay the monthly instalments on time. The ratio is lesser if the loan applicant has no financial obligations at that stage.
One good way to enhance this ratio is by increasing the net profit of the business. Another feasible way is to opt for longer loan repayment tenure. With a good debt to income ratio, any self-employed businessmen and entrepreneurs can easily get the loan sanctioned. My friend’s business incurred an amazing net profit in his business and it was reflected in the debt to income ratio and that in turn helped him to avail a home loan for a shorter tenure while buying one of the flats in Tambaram.
Ratio of debt to equity:
Another vital leverage ratio is debt to equity ratio and it shows the capacity of a firm or a business to repay long term debts. By calculating this ratio, the lenders can find out the entity’s financial position for a long term. When this ratio is high, it shows that the business/firm is majorly running on creditors finance rather than the investors funds.
All businesses and companies have to service the debt even if the profits from the business are very bad. With a good debt to equity ratio, the investor’s fund can be used to pay the operational cost of the business and make debt repayments at the same time even when the business is bad. So this ratio actually showcases the risk appetite of the applicant’s business and it is very specific depending on the industries.
Also check How is EMI for Housing Loans Calculated?