Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Ability to Pay

What it is:

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 it works (Example):

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 it Matters:

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.

Related Terms View All
  • Qualifying Widow or Widower
    Let's say John and Jane Doe have been married for 40 years. John is diagnosed with...
  • Market versus Quote (MVQ)
    MVQ is the difference between the last market price at which a security was bought or...
  • Macroprudential Analysis
    In the United States, stress tests are the most common example of macroprudential...
  • High Flier
    Let's say Company XYZ rises 45% in five days -- well ahead of the market's rise of 10%...
  • Narrow Basis
    For example, let's say the price of a bushel of wheat is $1 right now (this is called the...