UNDERSTANDING YOUR DEBT TO INCOME RATIO IS IMPORTANT FOR MANY REASONS
I want to take all of you into the world of Debt to Income Ratio or (DTI) because you should know about it even though many of you probably have never done the calculation.
Part of budgeting is understanding the health of your overall financial picture and to do that you need to understand debt in particular, your debt. What you see is not always what you have which is why clarity is important.
The amount of money a household owed relative to the money they earned late last in 2018 year saw Canadians owing $1.69 Market debt for every dollar of household disposable income.
Credit market debt as a proportion of household disposable income increased to 169.1 per cent as growth in debt outpaced income.- Stats Canada via Globe and Mail
If you’re not alarmed by that number, you should be.
Understanding YOUR debt
- What does consumer debt mean?
- What is good debt vs bad debt?
- What is your debt to income ratio?
Consumer debt everyone has heard of it but many don’t understand what it really means. Consumer debt is money you owe because you bought something with money you haven’t earned yet that don’t increase in value over time.
You know the new clothes you bought or the hair cut you put on your credit card? That’s consumer debt.
You’ll want to tackle consumer debt head on and fast because the longer it sits the more it’s going to cost you and you get nothing more out of the deal.
What are some types of debt you might hold?
- Consumer Debt
- Personal Debt (money you owe someone friends, family)
- Payday Loans
- Student Loan Debt
- Mortgage Debt
- Credit Card Debt
- Medical Debt (ex: Dentist, Cosmetic Surgery, Costs not covered under OHIP)
What is Debt to Income Ratio (DTI)?
The other thing I would look at is your debt to income ratio to figure out how much debt you have in comparison to your gross income.
Personally I’d go with using net income instead since that is the amount of money you get after paying taxes although lenders don’t like to get into the nitty-gritty of taxes.
It makes more sense to me but you’ll find that most online DTI calculators want your gross income as do the lenders.
If you want to play it real safe stick with your net income like we did when we went looking for a mortgage in 2009. Thankfully we did since my wife lost her job months after our first home purchase.
For example, if you gross $5000 a month and your mortgage is $1500, Car payment $500 and $500 to other bills your debt to income ratio is 50% which is very high.
Debt to Income ratio is a financial comparison that looks at how much debt you have to pay back in correlation to what you earn monthly.
When a lender decides whether to trust you with their money they will look at your DTI calculation to decide whether you can afford to pay them back. This is a big deal especially if you are looking to get a mortgage or some big-ticket item via a loan.
Everyone should know their DTI because understanding whether your financial health is in need of a boost is critical to the success of your money management skills.
If you carry a low DTI that means that you are capable of handling emergency situations that may arise with your finances whereas if your DTI is high you may not.
Look at debts that you have to pay back each month or that are recurring or fixed monthly payments:
- Auto loans
- Credit Card debts
- Student Loans
- Personal Loans
This is why lenders will be cautious with who they give money to and require your DTI as part of their decision-making process. If your DTI is too high this may signal to the lender that you are carrying too much debt and you could be a risk to lend money to.
Ideally keeping your DTI as low as possible will help you when looking to make a large purchase such as a mortgage.
Consider putting yourself in the lenders shoes for a moment. Would you lend money to yourself? If no, then consider making changes to the way you manage your money.
It’s my understanding that a 43% DTI and under is the safe zone for lenders but if you can get under that it’s even better. Discussing ways to lower debt before jumping into adding debt to your roster is ideal.
How to calculate your Debt To Income Ratio
The easiest way to calculate your DTI is to divide your debt payments by your gross monthly income which is a fairly simple calculation. Your DTI will be presented as a percentage.
Debt $2500/$5000 Gross Income = 0.5 or 50% Debt to Income Ratio
Good Debt vs. Bad Debt
The good debt vs bad debt debate is always going to be controversial but in our home we agree with what our financial advisor explained to us.
Years ago in a meeting we were having with our advisor I asked him what he considered good debt vs bad debt to be since he says that many of his clients struggle to invest in their retirement savings.
His answer seemed pretty simple;
- If it increases your net worth it is good debt
- If it decreases your net worth it is bad debt
Makes sense right?
In other words if you have an investment that can fluctuate such as your retirement savings or even a mortgage that would be good debt because you’ll likely come out ahead over time.
Bad debt on the other hand would be credit card bills or money you spend that you can’t pay back in full right away and doesn’t increase your wealth.
How to improve your Debt to Income Ratio
Budget, Budget, Budget… did I mention Budgeting will help improve your debt to income ratio? Well, it can.
Improving your debt to income ratio can be done one of two ways,
- Decrease your debt by paying it off
- Increase your income without any further debt
However you choose to improve your debt to income ratio is up to you but if your future plans include visiting a lender you’ll want to consider your options.
Limiting how much debt you take on is the ideal way to improve your DTI as well-paying off or lowering the amount of debt you owe. Keep in mind that paying less over a longer period of time means you are paying far more for something.
For this scenario think about cost involved when paying a mortgage to term, minimum credit card payments only or stretching the terms of a vehicle payment plan from 5 years to 7 years to lower the monthly costs.
Another option is to look at the current debt that you have and see if there are any ways to lower the amount of debt you owe.
For example if you have credit cards with high interest rates perhaps a balance transfer option would be ideal. What this does is help you by swapping a higher interest rate credit card to a lower rate even if it’s 6 months to a year.
Now that you understand what debt to income ratio is and how to calculate your debt to income ratio hopefully this will give you a bit more insight into ways you can tackle debt and work towards your debt freedom plan.
Discussion: Would you say using your gross income or net income when calculating your debt to income ratio is suitable and why? Leave me a comment below. Thanks.