When banks and governments talk of debt, they use some basic numbers and ratios that you can apply to your own life. Front-end ratios, back-end ratios, debt-to-income ratios, credit scores… These numbers can give you true insight to your financial situation, determine if you’re carrying too much debt and help you understand how qualified you are for loan or a mortgage.
What is your debt-to-income ratio?
It’s probably one of the most quoted terms by lenders when determining if they can approve you for a line of credit, loan or even a mortgage. But what does it mean?
This ratio compares how much money you make compared to how much you owe. In even plainer terms, it’s how much of your income is spent on debt.
To find out your debt-to-income ratio, first calculate your debt by adding up all the money you owe, from your credit card balance to your mortgage. Then calculate your annual income by determining how much money you make per year, after-tax.
Your debt-to-income ratio is the percentage of debt you have compared to your annual income.
So, for example, if your household owes $200,000, and you and your spouse bring in $100,000 as a team per year, your household debt-to-income ratio is 200 per cent.
That being said, it’s recommended that you keep your debt-to-income ratio at 36 per cent or less.
It may sound horrible, especially since the average national debt-to-income ratio was reported to be 171.1 per cent in the third quarter of 2017. But there’s a lot of criticism on using this number as a true measure of your financial health, as it makes people in certain stages of life look terrible (like young families with large mortgages) and others look overly good (such as those about to retire who have little debt). It should be noted that a debt-to-income ratio also don’t take equity or assets into account.
Why is my debt-to-income ratio important?
Your debt-to-income ratio can affect your ability to qualify for a loan or a mortgage. It seems daunting but lenders do use it as a preliminary measurement to make sure you’re not pushing yourself too far. The goal is to borrow money to improve your life, not put you at risk of deep debt.
Similar to those with a bad credit score, lenders see those with a high debt-to-income ratio as more likely to run into trouble making monthly payments.
How do I reduce my debt-to-income ratio?
Everyone’s financial situation is unique. So it’s understandable if your ratio percentage is in the hundred’s like many other Canadians. However, you should still take some action now if you are set on reducing your debt, such as:
- Pay down your credit card debt as quickly as possible. Same goes for lines of credit. And most importantly, tackle the debt with the higher interest rates first.
- If you’re about to buy a home, save as much as you can to use towards your down payment and make your mortgage smaller.
- Also, if you’re in the market to buy a home or coming up to renewal, compare mortgage rates before committing. There could easily be a better, lower rate available from another broker or bank. You can compare rates within minutes from over 30 mortgage brokers and lenders at RateSupermarket.ca.
- If you already own a home, double-up on payments from time-to-time to reduce your principal balance, which will then reduce the amount of interest you pay. This will positively impact your ratio.
- Switch to a lower interest credit card so you can get rid of credit card debt. The MBNA TrueLine® MasterCard®, for instance, offers interest rates dependent on your credit worthiness, from 5.99 per cent to 14.99 per cent. These low rates mean interest will not accumulate as fast as you can get rid of your balance.
- Another great way to chisel away at credit card debt is to take advantage of a card with a low balance transfer rate. The MBNA Platinum Plus® MasterCard® offers zero per cent interest on balance transfers for the first 12 months of card membership, meaning you can transfer the balance from a card that’s causing you grief and enjoy no interest for the first year – giving you time to pay down your debt. After the first year, however, a 21.99 per cent balance transfer interest rate applies.