Insufficient debt capacity means that an individual or business does not have the ability to take on a certain amount of new debt because allowable debt has already been incurred. For businesses, this restricts the opportunity to borrow money for expansion, and for individuals, it limits the amount they can borrow to finance various asset purchases.
Individual Debt Capacity
An individual's debt capacity is based on the amount of money he can borrow and safely repay. When people attempt to finance a house, car, boat and other major purchases, the lender typically calculates common debt-to-income ratios to get a sense of how much of the borrower's monthly gross income is already allocated toward debt obligations, and how much remains to comfortably put toward new debt.
Business Debt Capacity
A business's debt capacity is based on restrictions set in place by the business itself, borrowing restrictions and limits established by lenders, or both. Businesses typically borrow money to finance inventory, equipment and other types of major purchases. Just as lenders want to safeguard against individuals taking on more debt they than can comfortably pay back, the same is true with businesses. Some businesses establish their own debt guidelines in articles of incorporation or by-laws, because of a preference for moderating debt usage.
Home Loan Example
When prospective home buyers apply for a home loan, lenders typically use common debt-to-income and mortgage-to-income ratios to determine how much to lend. Conventional lenders usually use a 36 percent debt-to-income and 28 percent mortgage-to-income maximum as a guidelines, according to LendingTree. For instance, if you make $3,000 per month in gross income, your 36 percent debt threshold is $1,080. If your car loan, personal loan and credit card balances are $600 per month, this leaves $480 as a potential monthly mortgage payment. If you try to finance a purchase requiring $700 monthly payments, your lender might indicate you have "insufficient debt capacity" and tell you how much you can afford.
Increasing Debt Capacity
Debt capacity has two basic variables -- your income and debt amount. To increase your capacity to take on new debt, you must increase your income level, reduce your current debt, or both. For borrowers who make regular on-time payments without incurring additional debt, this is usually something that develops naturally over time. Paying down existing debt more quickly with extra principal payments can help improve your debt capacity faster.
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