What is a Debt Limitation?

A debt limitation is a mechanism that restricts the ability of a lender to take on additional risk by extending additional credit or funding to a client. The idea behind this type of restriction or limitation is to prevent lenders from becoming over-extended and possibly be unable to service all current covenants responsibly. While a debt limitation is primarily aimed at protecting the financial interests and stability of lenders, debtors also indirectly benefit from this type of restriction.

The determination of a debt limitation is often based on the total number of assets a lender has available to effectively manage his or her debt-service coverage ratio. Essentially, this means that based on the assets in hand, the lender can only extend credit or loans for up to a certain amount. Within this context, lenders will also evaluate the ability and likelihood of applicants to repay the amount of the requested loan within the terms defined and impose some type of limit based on those findings. Maintaining this type of equilibrium makes it easier for lenders to absorb losses that result from customer defaults, and continue servicing the accounts of other customers who are paying according to terms.

Debtors also utilize a debt limitation to protect their interests. For example, a company that wants to borrow additional funds may be able to make arrangements to obtain those funds if and when the company experiences a stable increase in its net income. This is because the degree of risk to the lender remains in roughly the same proportion, offsetting the additional borrowing with the increase in income. As a result, both parties continue to benefit from the business relationship without increasing the risk of financial hardship to either the lender or the debtor.

The concept of debt limitation can also be translated into a home budget. Here, the strategy is to keep debt obligations under a certain percentage of the monthly income generated by the household. This will often mean accounting for fixed debt expenses like a mortgage payment or a car loan, and minimizing credit card debt so that the total amount paid on debt each month leaves resources to meet other needs, including putting some money into savings. If this type of debt limitation strategy is successfully implemented and maintained, the household will retire net debt in a timely fashion, limit the creation of additional debt, and build a significant nest egg over the years.