Debt Capacity: What It Is and How to Calculate It Step by Step

Debt is something that many people view negatively and fear, often avoiding it at all costs. However, the reality today is that debt is often unavoidable, and the more you understand how the world of debt and credit works, the more you can use it to your advantage. How? We’ll explain in the following post.

What is borrowing capacity?

Borrowing capacity is the maximum amount of money that a person or company can borrow without jeopardizing their financial stability. It is calculated as a percentage of available passive income, and healthy debt is considered to be no more than 35% of total income.

The importance of knowing your borrowing capacity

Knowing your borrowing capacity helps you make responsible financial decisions and maintain solid financial health. It allows you to determine how much you can borrow without compromising your economic stability, thus avoiding situations of over-indebtedness that affect your quality of life.

Informed decisions

By knowing how much debt you can take on without compromising your financial well-being, you can realistically assess whether a new loan or line of credit is right for your situation. You will be able to compare different financing options and choose the one that best fits your needs and circumstances.

You avoid excessive debt

If you take on more debt than you can afford, you will likely have difficulty making your payments, which could lead to over-indebtedness. This causes stress, affects your credit history, and makes it harder to obtain future loans.

It helps you maintain a good credit history

A good credit history is essential to access better financing terms in the future. If you pay your debts responsibly and maintain a healthy level of debt, you will strengthen your credit history.

It enables you to achieve your financial goals

If you manage your finances responsibly and avoid excessive debt, you can save to achieve your financial goals, such as buying a house, a car, or taking a trip.

Provides peace of mind and control over your finances

Knowing your borrowing capacity gives you a better understanding of your financial situation and peace of mind that you are managing your debts responsibly.

Factors that determine your borrowing capacity

To fully understand what borrowing capacity is, it is important to clearly understand the factors that affect or shape it. That’s why we outline them below: 

Income

Financial institutions evaluate the applicant’s regular and stable income to determine their borrowing capacity. The higher the income, the greater the borrowing capacity.

Debt-to-income ratio (DTI)

This ratio compares monthly debt payments to monthly income. Lenders generally prefer this ratio to be low, as it indicates that the borrower has sufficient disposable income to take on new debt.

Credit history

Financial institutions review the applicant’s credit history to evaluate past behavior in relation to debt. A positive credit history, with on-time payments and no excessive debt, increases borrowing capacity.

Employment history and job stability

Job stability and a consistent employment history also influence the decision to grant credit. Lenders tend to prefer applicants with stable and consistent jobs, as this translates into a greater ability to repay debts.

Monthly expenses

In addition to income, lenders also consider the applicant’s monthly expenses, such as rent, mortgage, utility bills, insurance, etc. These expenses affect the amount of income actually available to pay off new debt.

Guarantees

In some cases, borrowing capacity may increase if the applicant is able to offer collateral such as property, a car, or other assets that can be used as security for the loan.

Loan term

The loan term also affects borrowing capacity. The longer the loan term, the lower the monthly payments, which may increase the amount of debt a borrower can manage.

How to calculate your borrowing capacity?

Below is a simple step-by-step guide on how to calculate your borrowing capacity: 

• Step 1. Add up your monthly income: Include your salary, rental income, investments, etc. Be sure to consider all regular income.
• Step 2. Subtract your fixed expenses: This includes housing, food, transportation, insurance, etc. Fixed expenses are those that you must pay every month, regardless of your income.
• Step 3. Subtract your variable expenses: Leisure, entertainment, clothing, etc. Here you should include all expenses that vary from month to month, such as birthday gifts, dining out, and social gatherings.
• Step 4. Multiply the result by 0.35: Once you have calculated the difference, multiply it by 0.35. This will give you the maximum percentage of your income that you can allocate to debt payments. Remember that healthy debt is considered to be no more than 35% of your income.

Example: If your monthly income is €1,000 and your fixed and variable expenses total €700, your borrowing capacity would be €105. This means you could borrow up to €105 per month without putting your financial stability at risk.

Tips to increase your borrowing capacity

Increasing your borrowing capacity is a strategic financial goal that can open many doors, from purchasing a home to launching a business venture. However, achieving this requires planning, commitment, and smart financial decisions. To help you get started, here are some tips: 

Increase your income

The first step toward greater borrowing capacity is to increase your income. This can be achieved by finding a better-paying job, taking on side projects, or investing in opportunities that generate passive income. The key here is to diversify your sources of income so that you are not solely dependent on your salary. Starting a business in areas that interest you or investing in the stock market are viable options, as long as you educate yourself properly about the risks and potential returns.

Optimize your expenses

Managing your unnecessary expenses efficiently is just as crucial as increasing your income. Drawing up a detailed family budget will help you identify areas of excessive spending. By cutting unnecessary expenses and seeking cost-effective alternatives in your consumption habits, you can free up a larger portion of your income for savings or investment. Renegotiating the terms of existing debts can also significantly reduce your monthly financial obligations.

Improve your credit history

Remember that a strong credit history not only improves your financing options but also qualifies you for more favorable loan terms. You can achieve this by keeping your debts at manageable levels, paying on time, and using credit strategically. Always monitor your credit history and correct any inaccuracies that could negatively affect your score.

Cultivate the habit of saving

Demonstrating the ability to save is essential for businesses, individuals, and families alike. This means having guaranteed investment funds set aside for emergencies and future goals. Good saving habits show prudence and foresight, qualities that are highly valued by lenders. You can choose the kakebo method for your finances, the 52-week savings method, or the 50-30-20 rule.

Seek professional financial advice

Navigating the complex world of personal finance can be overwhelming. Seeking advice from a financial professional can provide you with a personalized roadmap to improve your borrowing capacity, optimize your credit profile, and explore new investment opportunities.

Increase your borrowing capacity by investing in real estate

Investing in real estate is a traditional financial strategy that allows you to build wealth over time and increase your borrowing capacity. By purchasing a property, you are acquiring a tangible asset that may appreciate in value, while also gaining access to financing with lower interest rates and longer terms.
However, investing in real estate without sufficient knowledge can involve risks. That’s why Domoblock offers an innovative platform to invest in real estate through fractional ownership, giving you access to this market without the need for large amounts of capital.

• Invest with confidence: With Domoblock, you can become a real estate investor with as little as €200.
• Guaranteed return: Recoup your real estate investment in less than 8 months and enjoy an annual return of over 10% on a secure asset.
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• Revolutionary tokenization: With tokenization, you can easily invest small amounts thanks to our blockchain-based technology.
• Higher returns, lower costs: We use blockchain technology to reduce costs and increase returns, so you can achieve your financial goals faster than ever.

If you are ready to start investing or enter the world of real estate investment, Domoblock—the platform specializing in real estate crowdfunding and property tokenization, is your safest option. 

Conclusion 

In short, knowing your borrowing capacity allows you to make responsible financial decisions, avoid excessive debt, and maintain control over your finances. Remember that borrowing beyond your means can be harmful, increase stress, affect your credit history, and make it harder to access future loans. Take a broader view of debt and start evaluating the possibility of using it to build a strong credit profile that supports your future plans.