Our borrowing capacity is a calculation of the percentage of our income we can allocate to paying loan or mortgage repayments. In other words, it is the maximum debt someone could take on without putting their financial position at risk.
This is crucial information for avoiding taking on more debt than we can afford, and for understanding in advance how much debt we can take on.
Borrowing capacity is assigned to natural and legal persons and also to countries.
How is borrowing capacity calculated?
Financial institutions always analyse borrowing capacity before granting or turning down a loan or mortgage application. But a rough calculation is simple. Here is the formula:
Borrowing capacity = (income - expenses) x 0.35
A household's borrowing should not exceed 30%-35% of its total income. To understand our borrowing capacity exactly, we need to know all of our monthly income and expenses. A household's income can generally be divided into three broad blocks:
- Basic expenses The expenses that are part of our daily life, covering essential needs such as food, transport, children's education, clothing and leisure.
- Debt Repayment of borrowings to banks and financial institutions.
- Savings We should always save some of our income to provide a financial buffer against unforeseen events.
To make this easier to understand, here is an example:
A person earns 1,800 euros a month and has no other income. Their total expenses - basic expenses and a car loan - are 900 euros. This gives:
- Borrowing capacity = (1,800 - 900) x 0.35
- Borrowing capacity = 900 x 0.35
- Debt capacity = 315
This person could therefore contract debt of 315 euros per month. Applying this formula gives you an idea of what we mean by smart borrowing that does not put your finances at risk