Experts will tell you your debt-to-income ratio is one of the best ways to gauge your financial position. The media often quotes the Bank of Canada saying Canadians are at dangerously high levels of debt at 153%. But what does that mean? I've spent countless dinner parties arguing how to properly calculate debt to income ratios and how can you tell if your in the danger zone. There are many schools of thought on how to assess your financial health. Here are a few.
Your ability to service your monthly debt
Start by calculating how much fixed costs (debt) you have every month. These are costs you would pay even if you were away on holiday all month. This includes, mortgage, car payments, insurance, utilities, property taxes, minimum credit card payments and minimum student loan payments. Then calculate how much money you bring in as a household in one month. Your salary, your spouse's income and any money you make from investments.
Take the first number (your debts) and divide it by the second number (your income) and multiply it by 100.
Experts say, ideally you want this number to be less than 30%. If you’re between 30-40% be careful where you are spending your money and if you’re creeping close to 50%. You may want to cut back on some of your fixed living expenses.
Your total debt compared to your income
This is the debt to income calculation Statistics Canada uses to come up with that scary 153% figure. Take your total debts, home loan, car loan, line of credit and credit card debt. Calculate how much money you would need to say “I'm debt-free!"
Take that number (total debt) and divide it by your total annual household earnings after taxes (total income) and multiply it by 100.
Experts will say, if that number is under 130% you are in good shape. 130%-140% you are in a vulnerable position. More than 140% is getting close to the danger zone and more than 150% means you're operating at a debt level that would be hard to handle if interest rates were to rise 2%-3%.
Sorry! One more ratio
Canadians also need to look at their debt to asset ratios. This means the ratio of how much money you have if you sold everything compared to your total debt or liabilities.
Calculate all the debt you have outstanding. How much is left on your mortgage, credit cards, pesky line of credit and heck even your library dues. Who do you owe money to right now? Jot it all down. Then, add up how much your assets are worth, your house, car, stock portfolio any other investments, even your 60-inch T.V! Anything you own with a re-sale value. Imagine you’re moving to Argentina to start a new life and you had to sell it all.
Take how much you owe to everybody (total debt/liability) and divide it by how much your stuff is worth (total assets) and multiply by 100.
Again, experts say the higher the number the fewer assets you have to back up your debts and that’s not very good. For example, if your total assets are $1,000,000, but you owe $900,000. You ratio is 90%. You have little equity in your home and you’re the fakest millionaire around. But on the other hand if you owe $100,000 but your assets are worth $250,000 you are well backed by the equity or assets you already have in your home.
No need for online calculators
I’m not going to give you a link to any online calculators, because this is easy math that most of us can figure out and frankly most of the calculators make the situation more confusing. If you do the math yourself it will help you understand where you may be spending too much and what these numbers really mean.
The better ratio
In my opinion the better ratio is the one that calculates your ability to service your monthly debt. That is the number most banks use to understand your ability to pay your mortgage.
But that does not mean you should take a $1,000,000 loan just because the bank says you can afford the minimum payments. Calculate your affordability based on at least 2-3 percentage points higher in interest. This is the best way to protect your financial health. Even if you're on a fixed rate mortgage it means when your mortgage renewal comes up and interest rates are higher, you’re already well-positioned to make those higher payments.
But my ratios are so high! Don’t worry so are mine
- Rubina’s household ability to service monthly debt: 50%
- Rubina’s total household debt compared to income: 190% (OMG)
- Rubina’s household debt to asset ratio: 44% (yikes)
But, my husband and I are in our 30s. We pay our loans at a rate three percentage points higher than what the bank wants us too. If we were to lower our payment to the minimum, our monthly ratio would be lower as well. Also, we have no “bad” loans like credit cards or expensive lines of credit. We own our car and are conscious about our variable spending, so our ratio of household debt compared to income is decreasing every month. Finally, we bought our house two years ago and this is the most debt we will ever be in, as time goes on our debt to asset ratio will improve.
On top of this we're well prepared, in the last year we have built a 6 month rainy day fund and we both have substantial retirement portfolios and good job prospects.
You need to take all of this into account when you calculate your own affordability. The ratios are important, but always put them into perspective with your unique situation. Never live beyond your means.