What is the debt ratio?

In summary:

• The debt ratio is a tool used by banks to determine whether you are able to repay the loan you are applying for.
• This very simple formula calculates the weight of your debts and housing costs in relation to your income. It essentially serves as a thermometer of your borrowing capacity.
• A debt ratio under 30% is excellent, whereas anything over 40% is a red flag.

The strength of the debt ratio lies in the fact that it is used by all financial institutions whenever someone applies for a personal loan, a line of credit, or a mortgage.
Since it is a mathematical calculation expressed as a percentage, it also allows you to compare your financial situation over the years.

In fact, understanding and regularly monitoring this ratio can help you make informed decisions and maintain a healthy financial balance.

How to calculate your debt ratio

To assess your ability to manage your current debt level, start by adding your monthly housing costs to your total monthly debt payments (personal loans, car loans or leases, lines of credit, credit cards, etc.).
Then divide this amount by your gross monthly income (before taxes). The result, expressed as a percentage, represents your debt ratio.

Here are the specific budget items to consider:

If you want to simplify the calculation steps mentioned above, the professionals at Jean Fortin have created an online tool that allows you to measure your debt level in just a few minutes, safely and anonymously. We encourage you to use this tool as often as you like!

What does your result mean?

• A debt ratio under 30% is considered excellent, indicating that you can handle your debt payments without difficulty.
• A ratio between 30% and 35% is acceptable, but you should ensure the trend is not increasing.
• A ratio between 36% and 39% is riskier, as it approaches the upper limit of 40%–42%.
• A ratio above 40%-42% indicates a level of debt that is too high and may reduce your chances of getting credit at favorable rates.

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

Why monitor your debt ratio?

Regularly monitoring your debt ratio is essential to avoid falling into a debt spiral by taking steps to reduce your debt before losing control. A high debt level can seriously unbalance your budget, hinder your ability to save, invest, and achieve your financial goals, and make it harder to qualify for credit for personal projects such as buying a home. The higher your debt ratio, the higher the interest rates you may face on future loans, as financial institutions will see you as a greater risk.

What are the weaknesses of the debt ratio?

Its biggest strength is that it’s simple and universally used. However, the debt ratio has 2 main weaknesses:

1. Number of dependents: The ratio is based on the total income of an individual or household, but it does not consider the number of dependents relying on that income. For example, a single person earning $100,000 a year doesn’t have the same basic expenses as a family of four with the same household income. So, a debt ratio of 35% may reflect very different debt-handling capacities depending on the household size.
2. Expenses beyond housing and vehicle costs: The ratio only considers housing costs and debt related to auto loans or leases. While these are major budget items, there are many other expenses that vary greatly from person to person, based on lifestyle (travel, hobbies, high-level sports, etc.) or family situation, and that significantly impact the money available to repay debt.

So, relying solely on the debt ratio doesn’t guarantee financial stability. It is therefore also recommended to create a budget that considers all your expenses and gives you a clearer picture of your reality. Although this step takes more time than simply calculating your debt ratio, investing time in both aspects will give you a more accurate view of your finances.

If you have any questions or need help completing any of these steps or understanding your results, don’t hesitate to contact one of the personal finance trustees at Jean Fortin. It’s free, confidential, and with no obligation.

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