Effort Rate

This indicator is one of the most used by financial entities, whenever someone goes to a bank requesting a new credit or the revaluation of the existing ones. This ratio intends to measure the risk of granting credit to a person, household or company, as part of the analysis dossier in granting it, being one of the rules of good practice imposed by the regulatory entities: Banco de Portugal (BP) and Banco Central European Parliament (ECB).

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

Effort rate what is it and how is it calculated?

The effort rate is an indicator that measures the weight of financial expenses in relation to the total available household income .

In other words, with this ratio what we want to determine is: what is the financial "slack" that the borrower 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 granting 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 company (intended to pay installments related to interest or amortization on previous credits still active) and calculating the percentage of these in relation to the total income of the household:

Household 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 moving a home should also be included in the monthly total financial charges.

For example:

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

• The couple contracted a personal credit in the amount of 10 thousand euros, for which they pay a monthly installment of 231 euros;
• 2 Credit Cards that imply a total monthly charge of € 90;
• 1 Car loan, which adds an additional € 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 rate is at the limit of what is desirable.

For values higher than this, there may be a negative impact on the risk assessment by most banks, implying more unfavorable conditions in the granting of credit, namely if it is for the purchase of housing. 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 recommendations of the regulators are towards a reduction for 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 years in effect to the detriment of the interest installment, making the first years mostly to pay interest and not to amortize the loan;
• A higher spread rate, thus increasing the total interest rate to be paid on the loan (in the case of a mortgage loan);
• A lower ratio between the amount of the loan granted and the value of the property pledged as collateral (whose maximum allowed value is 90% for housing loans and 80% for the rest);
• The need to use third parties as guarantors of the loan;
• The need for additional guarantees;

Effort raterecommended

In the case of bank loan applications, Banco de Portugal recommended to banks in January 2018 that they limit the effort rate to the maximum amount of 50% for new loans.In other words, the supervisor recommends that the assignment of new credits can only happen if the total of the monthly commitments remains below 50% of its monthly net income. The recommendation extends to the guarantees provided and the maturities of the contracted loans, which are expected to meet tighter limits in view of the expected rise in key interest rates by the ECB.

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

However, the recommended monthly effort rate should not exceed 1/3 of the family income, ie 33% . What the reality has been showing is that bank entities, especially when it comes to a mortgage loan, hardly approve loans with an effort rate greater than 40%, unless the guarantees provided by the guarantor or the guarantor allow to minimize the risk.

How to reduce the effort rate?

Whenever the Effort rate exceeds 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 credit to another bank or financial entity that offers better conditions. In the latter case, pay attention to the penalty clauses that normally appear in the credit agreements in force.
• Credit consolidation - It is used whenever the number of credits is greater than one, allowing you to replace them with just one, with better conditions and less monthly charge. In other words, it pays a single monthly payment and a single loan, thus obtaining a consolidated credit . When consumer credits or card payments are involved, it is possible to reduce the amount of the installments up to 60%. There are companies in the market whose service is to achieve this consolidation of credits.