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

Debt is something that many people view negatively and fear, and therefore avoid at all costs. But beyond all this, the reality today is that debt is often unavoidable, and what's more, if you understand how the world of debt and credit works, you can use it to your advantage. How? We'll tell you in the following post.

What is borrowing capacity?

Debt 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 that which does not exceed 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 falling into 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 credit is right for your situation. You will be able to compare different financing options and choose the one that best suits your needs and possibilities.

You avoid excessive debt

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

It helps you maintain a good credit history.

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

It enables you to achieve your financial goals.

If you manage your finances responsibly and avoid excessive debt, you will be able to 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 knowing that you are managing your debts responsibly.

Factors that determine your borrowing capacity

To fully understand what borrowing capacity is, you need to be very clear about the factors that affect or shape it. That's why we're explaining them below: 

Revenue

Financial institutions evaluate the applicant's regular and stable income to determine their ability to pay. 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 service new debt.

Credit history

Financial institutions will review the applicant's credit history to assess their past behavior in relation to debt. A positive credit history, with timely 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 who have 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 to back the loan.

Loan term

The term of the loan also affects borrowing capacity. The shorter the loan term, the higher the monthly payments, which can reduce the amount of debt a borrower can handle.

How to calculate your borrowing capacity?

Here 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 your regular income.
• Step 2. Subtract your fixed expenses: This includes housing, food, transportation, insurance, etc. Fixed expenses are all those expenses 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, eating out, and social gatherings.
• Step 4. Multiply the result by 0.35: Once you have the result of the subtraction, multiply it by 0.35 to get a percentage. This is the maximum percentage of your income that you can allocate to paying off debts. Remember that healthy debt is considered to be less 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 that you could borrow a maximum of €105 per month without jeopardizing your financial stability.

Tips for increasing your borrowing capacity

Increasing your borrowing capacity is a strategic financial goal that can open many doors, from buying a home to launching a business venture. However, achieving this requires careful planning, commitment, and smart financial decisions. To help you out a little, 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 allow you to identify areas of excessive spending. By reducing unnecessary expenses and looking for economical alternatives in your consumption habits, you will be able to free up a larger portion of your income for savings or investment. Renegotiating the terms of your existing debts can also significantly reduce your monthly financial obligations.

Improve your credit history

Remember that a solid 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. Doing so will allow you to identify and correct any inaccuracies that could negatively affect your rating.

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. The advice of a financial professional can provide you with a personalized roadmap to improve your borrowing capacity. An advisor can help you adjust your financial planning, optimize your credit profile, and explore new investment avenues.

Increase your borrowing capacity by investing in real estate

Investing in real estate is a traditional financial strategy that continues to prove effective in increasing borrowing capacity. When you purchase a property, you are not only creating a tangible asset that appreciates over time, but you can also access financing with lower interest rates and longer terms. However, jumping into real estate investment without knowing much about investing or the real estate business is extremely risky. That's why at Domoblock we offer you an innovative platform for fractional real estate investment, allowing you to access this market without the need for large amounts of money. Through us, you can:

• 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.
• A global community: Join more than 350 investors from 12 different countries and become part of a diverse and thriving community.
• Quick registration with no fees: Our registration process is quick and transparent, with no hidden fees.
• Intuitive platform: Invest with just a few clicks through our 100% automated platform.
• Guaranteed security: Your investment will be protected. If we do not reach the funding goal, you will get your money back without any problems.
• Revolutionary tokenization: With tokenization, you can easily invest small amounts thanks to our blockchain technology.
• Higher returns, lower costs: We use blockchain because it allows us to reduce costs and increase returns, so you can reach your financial goals faster than ever!

If you are ready to start investing or venture into 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 is harmful, can cause stress, affect your credit history, and make it difficult to access future loans. Broaden your perspective on debt and start evaluating the possibility of using it to create a credit profile that benefits your future plans.