Effort Rate

This indicator is one of the most used by financial institutions, whenever someone resorts to a bank requesting a new credit or the reassessment of existing ones. This ratio is intended to measure the risk of granting credit to a person, household or company, forming part of the analysis dossier in the granting of the same, being one of the rules of good practice imposed by the regulatory authorities: Banco de Portugal (BP) and Central Bank European Union (ECB).

An entity qualified to grant credit authorizes, or not, the granting of the same according to several criteria, the Effort Rate is one of the main ones, even because it aims to create conditions of financial solvency in the medium and long term for the targeted ones.

Effort rate what is it and how is it calculated?

The effort rate is an indicator that measures the weight of financial expenses against the total disposable income of the household .

In other words, with this ratio what is intended to be determined is: what is the financial "slack" that the credit applicant has to face new debt commitments. In this way, it is possible to assess the risk that this credit entails, both from the point of view of the financial entity that grants the loan, and from the point of view of the financial health of the applicant.

How is the Effort Rate calculated?

The Effort Rate is calculated by adding all the expenses of the household or the company (intended for the payment of installments related to interest or amortization on previous credits that are still active) and calculating the percentage of these against the total income of the household:

The household's income may include salaries, disability or widowhood pensions, family allowances or other income.
Expenses with financial commitments include credit cards, personal loans, car loans, home loans, among others. Monthly expenses for renting a house should also be included in the total monthly finance charges.

For example:

A couple has a net monthly income of €1,500 (which is calculated by dividing the annual income by 12, after deducting the respective taxes).

• The couple took out a personal loan worth €10,000, for which they pay a monthly installment of €231;
• 2 Credit Cards with a total monthly charge of €90;
• 1 Credit for the purchase of a car, which adds another €167 to the total financial charges.

So we have an Effort Rate = (488€ / 1,500€) x 100 = 32.5%. This is a couple whose effort ratio is borderline desirable.

For values above this there may be a negative impact on the risk assessment by most banks, implying more unfavorable conditions in the granting of credit, namely for the purchase of a house. Some of the usual penalties are:

• The maturity of the loan can be shortened.The maximum limit on home loan contracts is 40 years, although the regulators' recommendations are for a lower limit to 30 years by the end of 2022 and 10 years for consumer credit contracts;
• The monthly debt amortization plan, which may be low in the first few years to the detriment of the interest portion, meaning that the first few years are mostly for paying interest and not for amortizing the loan;
• A higher spread rate, thus increasing the total interest rate payable on the loan (in the case of a loan for house purchase);
• A lower ratio between the amount of the loan granted and the value of the property given as collateral (the maximum amount allowed is 90% for mortgage loans and 80% for the rest);
• The need to resort to third parties as guarantors of the loan;
• The need for additional guarantees;

effort raterecommended

In the case of bank loan applications, the Bank of Portugal recommended to banks, in January 2018, that they limit the effort rate to a maximum value of 50% for new loans.In other words, the supervisor recommends that the attribution of new credits can only happen if the total monthly commitments remain below 50% of your net monthly income. The recommendation extends to the guarantees provided and the maturities of the contractualized loans, which must comply with tighter limits in view of the foreseeable increase in key interest rates by the ECB.

However, BP opened the door for banks to allow a maximum effort rate of 60%, up to one fifth of the total amount of loans granted in that year.

However, the recommended monthly effort rate should not exceed 1/3 of the family income, ie 33% . What reality has been demonstrating is that banking entities, especially when housing credit is at stake, hardly approve loans with an effort rate greater than 40%, unless the guarantees provided by the person or by the guarantor make it possible to minimize the risk.

How to reduce the effort rate?

Whenever the Effort rate is greater than 40%, it will be desirable to be able to reduce it through 2 alternatives at your disposal.

• Negotiation of existing credits – With the entities with which you contracted your credits, try to renegotiate the spread rate or the maturity of the loan.If not, explore alternatives to change the credit to another bank or financial entity that offers better conditions. In the latter case, pay attention to the penalty clauses that are usually included in the current credit agreements.
• Credit consolidation – It is used whenever the number of credits is greater than one, allowing them to be replaced by just one, with better conditions and lower monthly charges. That is, you pay a single monthly fee and a single loan, thus obtaining a consolidated credit . When consumer credit or card payments are involved, it is possible to reduce the value of installments by up to 60%. There are companies on the market whose service is to achieve this consolidation of credits.