When banks and governments talk of debt, they use some basic numbers and ratios. Do you know what yours are? Understanding these numbers can give you true insight to your financial situation, determine if you’re carrying too much debt and help you understand how the bank views you when you’re applying for a loan or a mortgage.
What Is Your Debt-To-Income Ratio?
This is a number you see often in the media as Statistics Canada releases the average Canadian number every quarter. The last release found that we’re at 150.6 per cent.
The ratio compares, quite simply, how much money you make compared to how much you owe.
To find out your own, add up all the money you owe, from credit card debt to your mortgage and then calculate what per cent that is of the after-tax money you make in a year.
So if your household owes $200,000 in total and you and your spouse bring in $100,000 as a team, your ratio is 200 per cent.
Sounds horrible! But there’s a lot of criticism of this number as it makes people in certain stages of life look terrible (like young families with large mortgages) and others overly good (such as those about to retire who have little debt but need a lot of savings).
Understanding Your Front-End Ratio
This number is all about home ownership and is used by the bank when deciding whether you qualify for a mortgage. Simply put, this is determined by looking at how much of your income is going towards making mortgage payments. This percentage-based number is your monthly housing expense divided by your monthly gross income.
So, if you spend $2,000 a month on your mortgage and associated costs and you make $100,000 a year, your ratio is 24 per cent.
The benchmarks vary, but ideally you should not go beyond 28 per cent for this number. In this case, you multiply your annual income by 0.28 and divide the answer by 12. If your household brings in that $100,000, your bank will probably say you can afford a maximum monthly housing expense of $2,333.
Know Your Back-End Ratio
This number is another favourite for approving mortgages as it takes into account the cost of servicing all your debts, including your mortgage and its associated costs, as well as credit card debt, other loans and the like. So, to figure this out, you take your monthly income ($8,333, for instance) and divide it by the cost of servicing all your debts each month. If you’re putting out $3,000 a month for mortgages and other debts, you’ll hit 36 per cent for your back-end ratio.
The magic number for this ratio is usually 36 per cent. So if you make that $100,000 a year, you multiply your monthly income by 0.36 it means the bank will think you can afford to cope with $2,999 in debt servicing a month.
So, do the math and see how things look in your world. If your ratios are troubling, look for ways you can trim your debts, such as:
- Pay down your credit card debt as quickly as possible. Same goes for lines of credit.
- Switch to a lower interest credit card (so you can get rid of said debt.) The MBNA TrueLine MasterCard, for instance, charges just 9.99 per cent on all purchases. This means interest will not accumulate so fast and you can get rid of your balance. Another great way to chisel away credit card debt is to take advantage of a low balance transfer rate. The MBNA Platinum Plus MasterCard offers a zero per cent balance transfer (it goes up to 19.99 per cent) after that, and a 17.99 per cent interest rate.
- If you’re about to buy a first home, save as much as you can for your down payment so your mortgage will be smaller.
- If you’re already in a home, make double-up or anniversary payments to reduce how much you owe — that will impact your ratios.
These challenging math problems may mean a lot to your ability to get a mortgage or a loan some day. They seem daunting but they’re an important ways lenders make sure you’re not pushing yourself too far. The goal is to borrow money to improve your life, not put you at risk.