Definition: The ability of a person (or business) to pay back money that is lent to him or her.
Example: Gary walks into a bank and requests a loan for a home he wants to buy. Before lending Gary the money, the bank employee asks Gary to provide information such as how much money he has saved up, how much he earns each year, how large his existing expenses are, and how much money he already owes to others. The banker looks at these things in order to judge Gary’s ability to pay the loan back.
Investeach explains: One factor that contributed to the financial crisis that exploded in 2008 is that in the years leading up to 2008, many banks virtually gave up on checking whether borrowers really had the ability to pay back their loans. Instead, they relied on the borrower’s own declaration of what he earned as well as his credit score. But, many borrower’s weren’t honest about their income. In fact, many were encouraged to lie by lenders who knew they were going to sell the loan for a profit to someone else soon after it was made. This became known in the industry as a “liar’s loan“. In addition, it turns out that credit scores weren’t a great indicator of whether a borrower would repay. In the end, the decision of lenders to not thoroughly investigate each potential borrower’s ability to pay turned out to be a costly mistake that put many financial firms out of business.
Riddle me this:
- What questions should a banker ask a potential borrow to assess the person’s ability to pay?
- In the years leading up to the 2008 financial crisis, why would a bank or mortgage broker give a loan to a person whom she has serious doubts about?
- What is the slang name for loans given to people who were not truthful about how much they really earned each year?