Debt-to-Income Ratio: What You Need to Know

If you read economic news, you are likely to have encountered many stories about the rising debt-to-income ratio of Canadians. Statistics Canada pays close attention to this measure of the level of debt Canadian households have to deal with; and they report that it is currently near an all-time high at close to 174%.

The Bank of Canada also keeps a wary eye on this measure of financial health because they fear that rising interest rates could suffocate some Canadians – especially the ones already struggling to make their minimum payments. The Bank explains that the amount of debt held by Canadian households has been growing fast for the last 30 years.

At the end of the day, the debt-to-income ratio is not only something Governments worry about – it’s also a ratio families should monitor closely because their lenders use it to decide whether or not they will approve a loan. Lenders weigh in the debt-to-income ratio because an elevated ratio is a telltale of financial vulnerability and by proxy, a higher risk of default.

What is Debt-to-Income Ratio?

The debt-to-income ratio – abbreviated as DTI ratio – is a measure of the amount of debt held by a person or household to the amount of disposable income they take in. It is calculated by summing all the debts held (mortgage, car loan, credit cards, credit margins, personal loans, etc.) and dividing by the yearly income (before taxes and other deductions).

How to Calculate Debt-to-Income Ratio?

Many online debt-to-income calculators are available, but the calculation is actually very simple and can be done using a standard calculator (or your smartphone!).

Debt-to-Income Ratio

Let’s take an example: Bob and Sue own a house, two cars and carry some credit card debt. Their mortgage balance is $150,000, their car loans, $30,000 and they have $20,000 in credit card debt. In total they owe $200,000 to various creditors. They also earn a combined salary of $140,000 before taxes. By dividing $200,000 by $140,000 we arrive at a DTI of 143%, or $1.43 of debt for every dollar of income.

Here is a full list of sources of income and debt not to forget when calculating your TDI ratio:

Income

  • Your and your spouse monthly income
  • Any alimony or child support you receive
  • Pension or retirement benefits

Debt

  • Mortgage
  • Car loan
  • Recreational vehicle loans: boat, ATV, camper, snowmobile, etc.
  • Credit cards
  • Credit margins
  • Personal loans
  • Student loans
  • Appliance and furniture loans
  • Medical bills
  • Other unpaid bills

The debt-to-income ratio should not be confused with the total debt service (TDS) ratio which is a measure of the portion of one’s income dedicated to making debt payments. The TDS ratio compares the monthly fixed debt payments to the monthly income. The TDS ratio is usually (and hopefully) below 100%, otherwise it would mean that the debt payments are greater than the income which would not be sustainable. A healthy TDS ratio is generally considered to be below 40-45%, but the lower the better.

Why Does It Matter?

If you are concerned with your financial health, then you will want to control your debt-to-income ratio. If you maintain a high DTI ratio throughout your life, it will be very hard for you to save enough money for retirement and accomplish your financial goals. You don’t want to remain enslaved to your debt all your life.

If you are just starting out and purchased a house or condo – especially in an expensive market like Vancouver, Toronto or Montreal – it is normal to have a higher DTI ratio for some time. However, you should strive to lower it over time; either by paying off debt or by increasing your income. (Pro-tip: paying off debt is actually easier and faster than getting a significant raise.)

Having a low DTI ratio will also make you more attractive to lenders because they will see you as a less risky borrower. Your DTI ratio is reflected in your credit score: a high level of debt will negatively impact your credit score because it increases the likeliness that you will default on your minimum payments. A good credit score and a low DTI is the recipe to get approved by lenders.

How to Improve Your Debt-to-Income Ratio?

At first glance, it’s purely mathematical: if you want to improve your debt-to-income ratio you must lower your total debt, increase your salary, or do both! And, as we’ve stated it before, it is usually easier to reduce debt, especially unnecessary debt like credit card debt.

However, more factors should be considered, such as the “quality” of the debt. Having a higher DTI ratio because you own a property in an expensive real estate market is not as worrisome as having a high DTI ratio because you have high levels of consumption debt such as credit cards.

Likewise, if your DTI ratio is high because you have refinanced your mortgage or taken out a second mortgage, then you are not headed in the right direction. Over time, your DTI should be going down, as you pay off your mortgage and increase your income.

Here are a few other tips to improve your debt-to-income ratio

  • Stop using your credit card for regular expenses (shopping, groceries, gas, etc.)
  • Consolidate your credit card debt to reduce your effective interest rate and pay it off faster
  • Go for a car loan of shorter duration (4-5 years instead of 7-8) so it disappears from your balance sheet sooner
  • Buy a house or condo that you can actually afford
  • Instead of buying a recreational vehicle – such as a boat – rent it. You might realize you didn’t have the time for it anyways.
  • Get a better paying job, ask for a raise, take a side job, or work overtime (but not too much!)

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