What is Debt Capacity?

Debt capacity is the amount of debt which a person or organization can carry without compromising financial stability. Depending on the situation, it may be estimated at up to half of monthly income receipts, although one third is a more commonly accepted number. The consideration of debt capacity is important when taking on new loans, renegotiating loans, or assessing financial viability.

Individuals and organizations alike can determine their own debt capacity by sitting down with some account books. After determining all sources of income, all expenses can be tallied separately to determine how much of the income is already accounted for. Considering this and weighing the need to have funds available for emergencies and the desire to put funds aside, it's possible to calculate how much monthly income can be spent servicing debt. This, in turn, can be used to determine how much debt can be carried within a set period of time.

Debt capacity can be complicated to calculate in some settings because people need to consider things like the term of the debt and the expense of the debt. Borrowing a sum comes with costs including loan origination fees, interest payments, late fees, and so forth. When considering debt capacity, people need to think not just about the principle of the debt, but also the associated costs, some of which may be hidden. For example, someone who is close to debt capacity may not be allowed to take out another loan, which means that people can't access credit in an emergency, and this is something to think about before borrowing.

Financial institutions usually arrive at their own determination of debt capacity when processing applications for loans. This determination is used to decide how much should be offered, and to adjust interest rates and fees. The maximum which can be lended may also be structured into a loan agreement. Debt capacity applies to revolving lines of credit as well as loans, and one thing banks may consider is how much access people have to credit, and how easily they could exceed their debt capacity if they go over their credit lines.

Thinking about debt capacity changes with the financial climate, and every financial institution assesses and thinks about risk differently. It is important to be aware of this when applying for loans and lines of credit, and to consider the fact that conservative institutions will not be inclined to underwrite a loan which skirts close to the maximum amount of debt someone can safely carry.