Why You Should Care About Your Debt-to-Income Ratio

There’s been a disturbing trend in Canada over the last decade: the debt-to-household-income ratio has consistently risen to the point where it’s now sitting at 171.1 per cent.

What that means is that for every $1 of disposable income that a Canadian household takes in, they owe $1.71. To put that into perspective, the debt-to-household-income ratio for Americans was 165 per cent before the housing crash of 2008. I’m not necessarily suggesting that there’s an imminent real estate crash in Canada, but the point is, Canadians owe record amounts of money. Too much of it.

So how does your personal debt-to-income ratio (or DTI ratio) compare to the average Canadian’s? And what is a healthy debt-to-income ratio anyway?

Understanding your debt-to-income ratio

A debt-to-income ratio can be calculated by adding all your debt payments together, then dividing their sum by your gross monthly income. The monthly debts to factor in refer to recurring, ongoing debts such as:

• Your monthly mortgage or rent payment
• Condo maintenance/strata fees
• Credit card payments
• Student loan payments
• Auto loans

For perspective, let’s say you have a gross income of $5,000 a month and you have the following fixed monthly expenses:

• Rent ($1,200)
• Car loan ($300)
• Other debt ($200)

Your total monthly debt adds up to $1,700. Since you have a gross income of $5,000, your debt-to-income ratio is 34% ($1,700 / $5,000). Generally speaking, the ideal debt-to-income ratio is anything under 43%. Use this calculator now to see how you stand.

Keep in mind that the debt-to-income ratio can be a bit misleading. The standard rule is to use your gross income to calculate your debt loads. But, everyone pays taxes, so doesn’t it make more sense to use net income instead? Lenders say it’s easier to use gross income since there are less variable factors to consider, but it’s up to you to decide how you want to manage your debt loads.

Why do I need to know my debt-to-income ratio?

The reason your DTI ratio matters is because lenders use it as a way to determine your ability to manage your monthly bills, lifestyle, and any potential loan that they may extend you. In other words, if you’re ever looking to get a major loan such as a mortgage, car loan, or student loan, you want to ensure that your current debt-to-income ratio is low enough to take on additional debt.

If your gross monthly income is $5,000, then your monthly debts should be no more than $2,150. At face value, that sounds pretty reasonable since that would leave you with $2,850 for the rest of your monthly expenses right? Not exactly.

Remember, the debt-to-income ratio is based on gross income. When you factor in the average taxes you would pay as a Canadian resident, your gross income of $5,000 per month is a net income of about $4,100 a month. After you pay your monthly debts, that leaves you with $1,250 in disposable income. That leftover income needs to cover all your other expenses, including vacations, retirement savings, insurance, raising children, and much more.

How to improve your debt-to-income ratio

Start by looking at the types of debt you have. If you’re currently carrying credit card debt, it might make sense to balance transfer to a low interest credit card. Standard credit cards have an average interest rate of 19.99%, whereas a balance transfer credit card might offer very low interest—between 0-3%—for a period of 6-12 months. The balance transfer card won’t give you many benefits, e.g. cash back or rewards, but it will give you a chance to halt the debt you accumulate due to high credit card interest rates.

If possible, try to limit the amount of additional debt you’re taking on. If you plan on financing the purchase of a car, give careful consideration to the terms of your loan. Automobile loan payments used to last no more than five years, but these days it’s pretty common to see loans with low minimum monthly payments, which last seven to eight years. Lower monthly payments might seem very attractive to a consumer in the short term, but it leads to paying a lot more interest long term.

Student loans can significantly elevate your debt-to-income ratio, since you’re essentially picking up debt before you start your career. Keep in mind that as a student, you’ll likely exceed the recommended debt-to-income ratio, since your income may be limited while you study. That’s ok, as long as the starting salary of the career you aspire to will be enough to keep your debt-to-income ratio manageable after you graduate and get a full-time job.

Another way to reduce your debt-to-income ratio is to increase your monthly income. Though an admirable financial goal, this might take longer than the act of reducing your debt, which you can probably accomplish on some level very quickly.