What Is Borrowing Capacity?
The borrowing capacity is the maximum amount that organizations or individuals can borrow without having any problem repaying the debt in full on time. Lenders must assess individuals’ capacity to take on debt before approving a loan to ensure the latter can repay the full amount with interest.
Borrowing power is one of the 5Cs of credit analysis along with character, capital, collateral, and conditions. Different factors impact an individual’s borrowing power including their assets, income, credit history, macroeconomic conditions, etc. Individuals can use a borrowing capacity calculator available online to determine the amount they can borrow.
Table of contents
- The borrowing capacity refers to the maximum loan amount that an individual or business can get based on their financial situation and live market data.
- All lenders determine the borrowing power of individuals or companies before offering financial assistance to understand whether they can make repayments on time.
- Individuals can take multiple measures to increase borrowing capacity. For example, they can pay off their existing debt, reduce monthly expenses, and increase their income.
- Lenders calculate an individual’s borrowing power, while credit reporting agencies compute one’s credit score.
Borrowing Capacity Explained
Borrowing capacity refers to the maximum amount that companies or individuals can borrow without putting their financial solvency at risk. All loan providers must assess an applicant’s borrowing power before sanctioning a loan. Otherwise, they may fail to recover the entire amount with interest. Simply having substantial deposits and multiple assets does not mean an individual has enough cash flow to repay a loan. A person’s borrowing power measures one’s ability to make ongoing loan repayments.
As noted above, multiple factors determine one’s borrowing capacity, and they may vary across different lenders. A crucial aspect that is out of a loan provider’s hands is the borrower’s risk appetite. That’s why the loan terms and amount can differ from one lender to another. Other factors that impact a person’s borrowing power are as follows:
- Assets and income
- Number of loan applicants
- Living expenses
- Credit History
In the case of organizations, the following factors impact their borrowing power:
- Financial ratios, such as leverage, coverage, cash flow, and profitability ratios
- Competitive position
- The management team’s strategy and track record
One must note that certain external factors influence a business’s borrowing power. They are as follows:
- An industry’s growth prospects
- Industry cyclicality
- Macroeconomic conditions
- The structure of the industry
Let us look at a few borrowing capacity examples to understand the concept better.
Suppose Jim wanted to avail of a home loan. So, he applied for one at three financial institutions — DMS Bank, ABC Financial Services, and PQR Bank, to see which lender offered the most favorable loan terms.
The first two financial institutions uniquely computed his borrowing capacity and offered a loan amount with certain terms and conditions. However, PQR rejected his application as his debt-to-income rate was more than 1. He compared the loan terms offered by DMS and ABC and picked the latter.
In January 2023, SkyWater Technology announced that it signed a new 3-year revolving credit facility, which has expanded its borrowing capacity. This new facility has an accordion feature, enabling the business to raise the facility’s size by $30 million, provided specific conditions are fulfilled.
The company expects to utilize this new facility to fulfill general corporate purposes. Such purposes may include providing support to internal growth initiatives and funding working capital.
How To Calculate?
Calculating individuals’ borrowing power involves ensuring that they have adequate earnings to pay for their commitments, which include living costs and liabilities.
There are two formulas that lenders typically use for this purpose:
- Debt-to-Income Ratio = Overall Debt/Overall Gross Income
- Net Surplus Income = Overall Net Income – Overall Repayments
Factors like the number of dependents, current personal or home loan repayments, private health insurance, and other financial obligations impact individuals’ expenses.
Generally, when computing a person’s overall loan repayments, lenders add a buffer of 2.5% to the interest rate. This stress test determines if an individual can repay their loan over the long term. One must note that lenders may have a base net surplus amount.
Moreover, some lenders may reject the loan application when the debt-to-income ratio is above 6 or 7. For example, if a person’s total income is $20,000 and their total debt is $140,000, the ratio will be 7. Hence, it is assumed that lenders accept 100% of the gross income in this case.
When computing borrowing power, an individual’s gross income varies across different lenders as they make alterations to determine the ‘assessable income.’
As noted above, individuals can determine their capacity to take on debt by using a borrowing capacity calculator. Such a tool is available online, and it is free to use.
How To Increase?
Let us look at the different ways to increase borrowing capacity.
- Earn More Income: Individuals must seek ways to generate more income to increase their borrowing capacity. For example, they can ask their employers for a pay rise if they have not received one for a long period. A higher salary positively impacts one’s borrowing power.
- Spend Less: Lenders subtract an individual’s expenses from the total income earned to determine the borrowing power. Hence, reducing monthly expenses is an easy way to boost one’s borrowing power.
- Reduce The Available Credit Limit: If individuals can access a substantial credit limit, it restricts their borrowing power. Hence, individuals may reduce their credit limit to increase their capacity to take on debt.
- Pay Off Existing Loans: Before applying for a new loan, individuals should try to pay off their existing debt, like personal or car loans.
- Increase Savings: Lenders usually want to see that borrowers have genuine savings, as this proves that they are financially responsible. Hence, ramping up savings can increase one’s borrowing power.
- Opt for A Longer Loan Tenure: The longer the loan tenure, the lower the repayments. Hence, one can increase their borrowing power by opting for a long tenure. That said, one must remember that borrowers must pay a higher interest rate if they choose a longer tenure.
Additionally, these are some measures one can take to increase their borrowing power.
- Choose a loan that requires a lower deposit
- Cancel unused credit cards
- Choose the right loan product
- Improve credit score
Borrowing Capacity vs Credit Score
The concepts of borrowing power and credit score can be confusing for individuals stepping into the financial world for the first time. That said, they can avoid any confusion regarding the meaning of the two terms if they understand how they differ. So, let us look at their distinct characteristics.
|This is the maximum amount of financial assistance a lender can offer a borrower based on the latter’s live market data and credit information.
|This is a score given by credit reporting agencies based on an individual’s creditworthiness.
|Lenders measure borrowing capacity.
|Credit bureaus like Equifax and TransUnion measure one’s credit score.
|Individuals’ salary impacts their borrowing power.
|Salary does not affect one’s credit score.
Frequently Asked Questions (FAQs)
Irrespective of whether an individual is a salary sacrificing for a pension, a child’s school fees, or a vehicle, it can impact their borrowing power and loan application. That said, certain lenders evaluate borrowers’ gross income using regular tax rates. In such cases, individuals working for a non-profit organization typically have a significantly higher income (after tax) than those with a similar gross salary. Resultantly, their chances of getting approval for a loan increase.
Generally, a deposit significantly impacts one’s borrowing power. The higher the amount an individual saves for a deposit, the better their borrowing power. Thus, it becomes more straightforward for them to avail of a loan if they save for a deposit.
It is the ratio of a nation’s borrowing to the exports consistent with a long-term upper limit on the debt service ratio.
The factors impacting a nation’s borrowing power are as follows:
– Currency volatility
– GDP or gross domestic product growth
– Interest rate levels
This article has been a guide to what is Borrowing Capacity. We explain how to increase it, its examples, how to determine it, and compare it with credit score. You may also find some useful articles here –