What is the debt ratio?

At 1st glance, the debt ratio may seem like a financial term that only financial institutions can understand. However, it’s quite the opposite.

The debt ratio is a simple formula that measures your financial ability to pay your debts.

It is not perfect, but its strength lies in the fact that it’s used by all financial institutions whenever someone applies for a personal loan, a line of credit, or a mortgage. Since it’s a mathematical calculation that yields a result expressed as a percentage, it allows you to compare your financial situation over the years.

Indeed, understanding and regularly monitoring this ratio could help you make more informed decisions and maintain a healthy financial balance. In this article, we’ll explore in detail how to calculate your debt ratio, why it’s essential to monitor it regularly and what its limitations are.

How to calculate your debt-to-income ratio?

To determine how well you can pay your current debts, simply add your monthly housing expenses and the total of all monthly payments on your debts (personal loans, auto loans/leases, lines of credit, and credit cards). Then, divide the total by your monthly gross (before tax) income. The result is expressed as a percentage.

Here are the budget items to consider in more detail:

If you wish to simplify the steps of calculating your debt ratio mentioned above, Jean Fortin’s professionals has an online tool that allows you to measure your debt level in just a few minutes, securely and anonymously. We encourage you to use this tool as often as you like!

What does your debt ratio mean?

• A debt ratio below 30% is considered excellent, indicating that you can manage your debt payments without difficulty.
• A ratio between 30% and 35% may be acceptable, but it is advisable to ensure that the trend is not increasing.
• A ratio between 36% and 39% is considered more risky as it approaches the threshold between 40% and 42%.
• A ratio above 40% and 42% indicates a too high level of debt and compromises your chances of obtaining credit at favorable rates.

We suggest using our tool to calculate your debt level to receive personalized recommendations for improving your ratio based on the result you obtain.

Why monitor your debt ratio?

Regularly monitoring your debt ratio is essential for anticipating potential financial problems, taking steps to reduce your debts, and maintaining long-term financial stability. A high level of debt can compromise your ability to save, invest, and achieve your financial goals, in addition to making you less eligible for credit for personal projects such as buying a home. The higher your debt ratio, the higher the interest rates applicable to a potential loan will be due to the higher credit risk.

What are the weaknesses of the debt ratio?

Its great strength is that it is simple and universal. However, the debt ratio has 2 major weaknesses:

1. Dependents: The ratio is based on an individual’s or family unit’s total income but not on the number of dependents relying on that income. A single person earning $100,000 a year does not have the same basic expenses as a family of four earning the same total family income of $100,000. Thus, with a debt ratio of 35%, for example, a person may not represent the same ability to pay debts due to higher expenses for food, clothing, etc., compared to what a single person will have to bear..
2. Housing and vehicle expenses: Secondly, the ratio only takes into account expenses related to housing, car loan/lease and other debts. Although these two first items represent the most significant expenses in a budget, there are numerous other expenses that vary greatly from person to person (travel, leisure, food, high-level sports, etc.), and which can have a major impact on the money available to handle your debts.

Therefore, relying solely on the debt ratio is not sufficient to get the whole picture. You should also work on a budget that takes into account all of your expenses and provides a more accurate picture of your reality. Although this may take a little more time than simply calculating your debt ratio, investing time in these two aspects will give you a better idea of your finances.

If you have any questions or need assistance with any of these steps or the results obtained, feel free to contact one of Jean Fortin’s personal finance advisors. It’s free, confidential, and without obligation.

By Pierre Fortin
Jean Fortin & Associés
Personal Finance Advisor
Authorized Insolvency Trustee