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January 26, 2012

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Getting to Know Your Debt-to-Income Ratio

by Editor

Do you know your debt-to-income ratio? If you’re like most Canadians, the answer is no. Unfortunately, failure to fully understand this important element of your financial portfolio could cause you grief when it comes time to secure a mortgage pre-approval. Luckily, calculating your debt-to-income ratio is easy – all you need is a good financial calculator and a few necessary numbers.

Why It’s Important

Your debt-to-income ratio is important for a number of reasons. First, it’s one of the best ways to gauge whether you are in good financial position to borrow money. Second, it’s a great way to review your spending habits and monitor your debt load. Understanding your debt-to-income ratio is relatively easy; each quarter, Statistics Canada published a report containing the average Canadian’s debt-to-disposable-income ratio. With any luck, you’re number should fall well below the average (in 2011, the national debt-to-income average was a hefty 153 percent.)

How Can You Calculate It?

To get your debt-to-income percentage, simply add up your total debt (this should include any mortgages, lines of credit and credit card debts). Then, find out what percent that is of your annual income (after taxes, of course.) For example, if your total debt is $140,000 and your after tax income is $75,000 your debt-to-income ratio is 187.

How To Tell If You’re in Trouble

Common sense would have you think that any ratio above the national average is bad, but this isn’t necessarily the case. Though it’s often referred to in reports and news stories, your debt-to-income ratio is actually quite limited when it comes to measuring your overall financial stability. This is because it doesn’t take into account your equity or any of your assets. More importantly, the debt-to-income ratio tries to compare apples to oranges: namely your entire debt to one year’s net income.

While flawed, your debt-to-income ratio is still an important qualifying mortgage factor. Banks and other lending institutions will often request your debt-to-income ratio in order to gauge your ability to repay debt. Those home hunters who have a low ratio are thus assumed to have a better chance of carrying a larger mortgage. Individuals with high ratios are considered credit risks and are often rejected.

So, What’s a Good Ratio?

According to Consolidated Credit Counseling Services of Canada, your debt-to-income ratio should by 36% or less. This is the ideal amount that an individual can comfortably carry. If your debt-to-income ratio is higher than 50% the Credit Counseling Service recommends seeking professional assistance to severely reduce the debt load.

Another Way To Monitor Your Debt

If your gross monthly-income ratio isn’t the best way to monitor your debt load, is there another option? Yes. Take your total monthly debt payments, including your mortgage, minimum credit card, and other regular expenses. Divide this by your total household monthly income. Finally, multiple this by 100. This method of comparing your debt-to-income ratio focuses on two direct comparables. By measuring the income you have coming in against the expenses that you have going out you’ll have a better understanding of whether or not your current situation is financially healthy.

How to Deal With a High Debt-to-Income Ratio

If your debt-to-income percentage is high, don’t just throw in the towel. There are two ways to try and tackle your situation:

  1. Lower your monthly debts (the quickest way is to avoid charging as much to your credit card)
  2. Increase your monthly incomes

Obviously, this isn’t as easy as it sounds. A better way to tackle your debt is to focus on your big ticket debt items. Take your mortgage, for example. Mortgages account for two-thirds of Canadian household debt and are one of the biggest strains to a budget. Consider opting for accelerated bi-weekly payment plans or using a prepayment┬áprivilege┬áto get back on track.

Worried that you’re carrying too much debt? Consider refinancing your mortgage for a more affordable rate.

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