Debt Ratio – Understanding your debt to income ratio
Debt to income ratio is a number that tells you how much your debts cost each month in relation to how much money you’re bringing in. Your debt to income ratio demonstrates the balance between your income and debt (it’s like a litmus test for your budget), and can signal whether you’re spending more money on debt repayment than what you earn.
A high debt to income ratio might make it difficult to qualify for loans and credit, since lenders consider how much money you have left in your budget after debt repayments when deciding whether to approve you for credit. On the other hand, a low debt to income ratio will likely make it easier to qualify for credit, as it is reflected positively on your credit score and indicates financial wellbeing.
How do you calculate debt to income ratio?
The calculation for debt to income ratio is your monthly debt repayments divided by your total monthly income (before taxes).
For example, let’s say someone earns $ 4,000 monthly and their debt repayments each month are as follows: $ 1400 mortgage payment, $ 600 car payment and a $ 500 student loan payment. First, we would add up the debt payments ($ 2,500). Next, we divide this number by the person’s monthly income.
Here is the debt to income ratio calculation for our above example:
2,500 ÷ 4,000 = 0.625
Then, multiply that number by 100 to view your debt to income ratio as a percentage. In our example, this person is spending 62.5% of their monthly income on debt repayment.
What is a ‘good’ percentage of debt to income ratio?
Most experts agree that you should aim for a debt to income ratio of no more than 36% – anything higher might affect your ability to get credit. If your debt to income ratio is higher than this number, it’s likely time to reevaluate your financial situation. Take a look at what debt repayments you’re making. Are they short term / temporary or a long-term commitment like a mortgage?
Perhaps you just graduated from post-secondary with some student debt. After working full time for a few years and putting some money towards your student loan, you’ll likely lower your debt to income ratio over time. However, if you’re facing long-term debt, you should tackle your financial situation sooner rather than later.
What if my debt to income ratio is higher than 1?
A debt to income ratio above 1 means you’re spending more money on debt repayments than what you earn, and it’s time to take greater control of your finances.
Don’t worry – lowering your debt to income ratio is within reach. We’ve offered some tips below to help you lower your debt to income ratio and get your finances back on track.
How can I lower my debt to income ratio quickly?
Luckily, most people can lower their debt to income ratio by making a few simple lifestyle changes:
- Limit credit card purchases: Don’t make credit card purchases that you can’t afford to pay back by the time your bill is due. Otherwise, you’ll owe interest on your balance. Over time your credit card balance will increase, along with your minimum payment amount, and subsequently your debt to income ratio (check out this article for more credit card tips).
- Ask your lenders how you can access lower interest rates: Lower interest rates equal lower loan or credit card balances, meaning lower payments and a lower debt to income ratio. Ask your lender if there are any opportunities to qualify for a lower interest rate, like choosing a secured loan, or consolidating high interest debt with a loan that has a lower interest rate.
- Make extra loan payments: Take any extra income (money you receive as gifts, tax benefits, bonuses etc.) and put it towards your debt to lower your total balance. Plus, consider making lump-sum payments at the end of your mortgage term to lower future payments. The more debt you eliminate the lower your debt to income ratio.
- Earn more income: Earning more money is a win-win. First, you’ll have extra money to put towards paying down debt. And second, earning a higher income will instantly lower your debt to income ratio. Need some inspiration? Check out these simple tips for earning extra income on the side.
- Downsize: While this solution is less ideal, there may be an opportunity to lower your mortgage payment by selling your house and downsizing. This might take some consideration, but it’s always an option if your debt to income ratio is on the high end of the spectrum.
Tip : focus on paying off higher-interest debts (and unnecessary debts) first, like a credit card, before tackling lower-interest debts like a car loan or mortgage.
Canadian debt to income ratio
If you’ve been reading headlines lately, you’ve likely heard the buzz about Canadian debt to income ratios. Articles describing “record high” Canadian household debt and fear of what that might signal for the economy are in no short supply. It’s no surprise with the rising cost of living. In fact, at the end of 2018, Canadians were spending on average 170% of their income on debt. Or put another way, Canadians owed $ 1.70 of debt for every dollar they earned.
So, if your debt to income ratio is on the high side, understand that you’re not alone. However, it’s still crucial to monitor how this number changes over time so you can prepare yourself for your financial future. The more you monitor and maintain a low debt to income ratio, the easier it will be for you to:
- Access credit (like a mortgage or car loan)
- Qualify for lower interest rates
- Save money, since less of your income will go towards debt payments
- Maximize the benefits of RRSP and TFSA savings accounts
- Reach financial goals and milestones