Credit Capacity: Definition, Ratios & Examples

Instructor: Yuanxin (Amy) Yang Alcocer

Amy has a master's degree in secondary education and has taught math at a public charter high school.

After reading this lesson, you'll have a better understanding of credit capacity and the various ratios used to determine whether or not you can quality for certain loans.

Definition

This lesson talks about credit capacity and the various ratios it uses. By definition, credit capacity refers to how much credit you are able to handle. In deciding whether you qualify for a particular loan, your income is considered along with any other expenses and debts you may have.

This is important information to have if you are considering getting a loan to make a big purchase, such as buying a new car or buying a house, for example.

Let's take a look at some of the ratios used in calculating your credit capacity.

Debt to Income Ratio

The first ratio we'll look at is the debt to income ratio (DTI). This ratio takes your recurring monthly debt payments and divides them by your monthly income.

DTI = recurring monthly debt payments / monthly income

The resulting ratio is then shown as a percentage. The lower your DTI, the higher your chances are of getting approved for a large amount of credit, such as a house. According to Investopedia, you generally want your DTI to be less than 43 percent if you want to be approved for a home mortgage. DTI is used to determine whether a particular person has the ability to pay back a potential loan.

Let's take a look at how the DTI is calculated.

An Example

Let's calculate Mark's DTI. Mark owns his own house with a monthly mortgage payment of $1,200. He also has a car payment of $600. He has no other debt payments since he pays off his credit cards every month. If Mark earns $8,000 each month, his DTI is ( $1,200 + $600 ) / $8,000 = $1,800 / $8,000 = 0.225 = 22.5 percent. Mark's DTI, at 22.5 percent, is pretty low, and it is likely that he will be approved for more credit if he so chooses.

Debt to Equity Ratio

The other ratio we'll talk about is the debt to equity ratio (D/E). This ratio takes your total liabilities and divides it by your equity, which is your total assets minus your total liabilities.

D/E = total liabilities / ( total assets - total liabilities )

Just like the DTI, your D/E is expressed as a percentage. Also, the lower your D/E, the more likely you'll qualify for a loan. A low D/E means you have a relatively low amount of debt, making it safer for a lender to give you a loan.

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