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May 11

How Does Interest Rate Affect Your Borrowing Capacity?

Reading Time: 4 mins

One of the first things to work out when you need funds to purchase a home, expand a particular business, or cover an unexpected expense is the amount of money you can borrow. By knowing how much you can borrow, you can run through your options and make a more informed financial choice.

Several factors affect your borrowing capacity and interest rate is just one of them. We discuss below how interest rates can influence the amount a lender allows you to borrow.

 

What Is Interest Rate?

When you borrow money or take out a loan, you are expected to repay it with an interest. The interest is typically the percentage the lender charges you for using their money. Charging interest is one way lenders make their profit.

They calculate the interest rate in either of the following two ways:

  • Fixed Interest Rate. If your loan has a fixed interest rate, you’ll pay the same rate over the life of the loan. It means that your payment stays the same every month until the term of your loan expires.
  • Variable Interest Rate. If your loan has a variable interest rate, you may start paying a low rate and end up paying more a few months later. Your interest rates go up and down during your entire loan term.

 

How Are Interest Rates Determined?

The interest rate charged by banks and other financial institutions depends on the interest rate set by the Federal Reserve (Fed), the country’s central bank. When the economy is growing, the Fed will increase the interest rate to reduce the risk of excessive inflation. But when the economy slows down, the Fed lowers the interest rate to stimulate economic growth.

It’s worth pointing out that interest rates are not determined by the bank or lender’s whim. However, it is greatly dependent on the changes made by the Fed now and then.

 

The Impact of Interest Rates On Your Borrowing Capacity

Without you realizing it, every change and decision the Federal Reserve makes quietly influences some aspects of our lives, such as borrowing or taking out a loan. When they raise or lower interest rates to stabilize the economy, it can positively or negatively impact your borrowing capacity.

Here’s how the rising and falling of interest rates affect your ability to borrow money or take out a loan.

 

When Interest Rates Rise

When the Fed raises rates, borrowing money tends to become more expensive since banks and lenders also typically charge higher interest rates on their credit products. In effect, the amount of loan you can afford might be less than when the rates are low.

Rising interest rates can also affect your ability to obtain financing. Banks are likely to reduce lending opportunities due to the risk of borrowers not being able to pay back such interest-rate hikes. You could pay hundreds of dollars more on regular mortgage payments and credit card bills.

When interest rates rise, the cost of short-term borrowing will also have higher rates than those considered long-term. It can be more difficult for you to manage repayment within a short period. Hence, your borrowing capacity is more likely to be limited when rates are high, and loans are costing you more than necessary.

 

When Interest Rates Fall

On the other hand, the cost of borrowing becomes cheaper when the Fed lowers the rates. Banks and lenders will also charge less interest on their loans. As a result, you can afford a larger loan since the repayment is likely to be cheaper and more manageable.

When interest rates are falling, consumers and firms are encouraged to borrow money or take out loans to increase spending and revitalize the economy. Thus, there will be more financing options and opportunities for any borrower.

Falling interest rates would make it easier for you to get approved for loans from banks and online lenders, like Credit Ninja, with better rates and repayment terms. Since interest rates are more affordable, your borrowing power is more likely to increase.

 

Other Factors To Think About

Interest rates are not the sole determining factors of your borrowing capacity. Banks and lenders look at other factors to determine how much they can lend you.

Familiarizing yourself with the following factors can help you increase your borrowing power regardless of the current Fed rate.

  • Stated Income: Lenders may look at your income when weighing your ability to make repayments. The greater your capacity to repay the loan, the more money you can borrow.
  • Current Debts and Living Expenses: Any current debts or expenses you regularly put your income towards could affect your repayment capacity. As a result, lenders consider your debts and living expenses when determining the loan amount you can afford.
  • Deposit Amount: A generous deposit of at least 20% indicates that you’re able to save money over a certain period. This shows the lender your ability to fulfill financial obligations.
  • Credit History: How you managed your previous credit plays a role in your borrowing capacity. If you have missed or late payments in your credit file, lenders are less likely to extend you the loan.

 

Important Reminder

Timing plays an essential role in your borrowing capacity. In a low-interest environment, the cost of borrowing is cheaper, which may allow you to afford a larger loan. However, the way you manage your personal finances can have much bearing on your repayment capacity and your borrowing power.

 

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