Evaluating your borrowing capacity

Before taking out a loan - especially a property or home loan - it is important to accurately determine the amount you are able to repay each month to avoid debt building up. In other words, to find out your borrowing capacity. But what exactly is it, and how is it calculated? What is the maximum capacity agreed by the bank and what happens when it is exceeded?

Borrowing capacity, also called repayment capacity, refers to the maximum amount you can spend on monthly repayments on loans, based on your income and other outgoings. Two main approaches are typically used, sometimes combined, to evaluate this borrowing capacity, i.e. debt level calculation and disposable income calculation.

Debt level calculation

The debt level calculation consists of comparing your income and your outgoings to evaluate the percentage of income taken up by recurring expenses. Calculation of income includes the following: salary after tax, other work-related income (profits from self employment for farmers, retail outlets, tradesmen and independent professionals), court-ordered maintenance payments, and other welfare payments such as pensions or incapacity payouts. Depending on the lender, other income might be included, such as family allowance, housing benefit, welfare, or commissions such as might be earned by sales representatives. Irregular income, such as one-off bonus payments or work-related compensation, is not included. As regards outgoings, the debt level calculation before new borrowing includes monthly repayments for current loans (consumer loans, vehicle loans, home loans if you are already a homeowner), monthly rental payments (if you are a tenant and your loan is not a home loan), maintenance payments to your spouse and any other recurring outgoings (telephone, gas, electricity, etc. bills).

Let’s take a simple example. Imagine a couple, with net aggregate monthly income of €8,000 and monthly outgoings of €1,600 (€1,200 miscellaneous costs and €400 on car loan repayments). Their current debt level is 20% (€1,600 / €8,000 x 100). For most financial institutions, when outgoings are more than a third of monthly income, the risk of excessive indebtedness or insolvency strongly increases. The income remaining to pay ongoing costs and provide room for manoeuvre for contingencies is limited, and exposes the borrower to potential difficulties. In our example, the borrowing capacity available to the couple is €1,040 (€8,000 x 33% - €1,000) per month. Above this sum, the bank could refuse to grant the loan... unless the calculation of disposable income is favourable to them. 

Calculation of disposable income

Disposable income equates to the sum remaining available once you have paid all your outgoings. It is used to determine what is left to enable you to live normally and ensure that unavoidable ongoing spending is met, such as food, transport and childcare. This closer analysis of your budget can encourage banks to make an exception to the 33% rule to grant a loan. It all depends on your household’s situation - are you single or in a couple, with or without children? - on your location - close to Luxembourg or some distance away? - on your property situation - are you a tenant or homeowner? - and on your current and future income - is it high, or even very high, or are you a young person with high earning potential? If, ultimately, the bank believes your disposable income comfortably covers your requirements, it will have no difficulty granting you a loan.

You will have grasped the point that whether a bank grants you a loan will depend in large part on its credit policy and your relationship with the bank. In other words, just because your borrowing capacity exceeds the 33% threshold, your request will not automatically be turned down.

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