We regularly hear about the debt ratio (also known as “debt ratio” or “debt level”) in the media (here, here and here again). It is indeed an important financial indicator to know the financial health of an individual or a company. An explanation over at http://wonderfactory.org
A bank, a financial institution, a lender, an investor or other will certainly want to know your debt ratio before you give more credit. This is normal because this indicator makes it possible to judge if you will be able to respect your monthly payments taking into account your income.
How to calculate your debt ratio?
The calculation of the debt ratio is relatively simple. It is a question of adding all his income (work income, pensions, investment income, rent income, etc.) and dividing it by the sum of his recurring monthly payments (car payment, rent or mortgage). insurance, taxes, municipal and school taxes, payments on debts, etc.).
The result of this calculation gives a figure that can be expressed as a percentage, which is your debt ratio.
It is important to note that expenses not arising from “debts” in the broad sense are not counted in monthly payments. Thus, grocery, restaurant, telephone / internet / cable, electricity (Hydro-Québec), gasoline, recreation, etc. expenses will not be counted.
What is a “good debt ratio”
Beyond the calculation of the debt ratio, one must understand what the result means. In all cases, a low debt ratio is preferable. However, one should not worry if it is below 30% .
- 0 to 30%: Excellent
- 30 to 35%: Acceptable
- 35 to 40%: At risk
- More than 40%: Danger
If your debt ratio is above 40% , your situation is considered critical and you will have a hard time getting new credit. In addition, for your own financial health, you should stay away from such a high level of debt so that you have enough money for your savings and essential expenses like groceries, gas and some Hobbies.
How to reduce the level of debt?
If your debt ratio is critical and you want to lower it, there are no miracle recipes. You must either (1) increase your income and / or (2) reduce your monthly recurring payments.
To increase your income, you might consider getting a salary increase, changing jobs or finding a second source of income. This option is far from easy for everyone and may not solve the real underlying problem, the lack of control over your expenses.
So, you can turn to the second solution, which is to reduce your monthly payments. To do this, the very first thing to do is to stop buying on credit. Whether it’s your furniture, appliances, travel, renovations or anything else, these are expenses that should be paid in cash. This kind of spending is frequently the reason behind a high level of debt.
Then, review your budget and make sure to respect certain ratios for your expenses in housing and transport. Your home should not cost you more than 25 to 35% of your disposable income and you should not exceed 15% for your transportation expenses (car, gas, maintenance, insurance, etc.).
Of course, you can adjust these numbers if you are willing to make some concessions elsewhere in your budget. However, remember that it is the recurring monthly payments that count in the calculation. So, if you cut food for the benefit of your home, it will negatively affect your debt ratio even if in total, your expenses are equal.
What if my financial problems affect my debt ratio?
If over the years you have accumulated a large amount of debt and you realize that a large part of your budget is confined to the payment of these debts, solutions are available to you.
First, you can turn to your financial institution and ask for debt consolidation. Debt consolidation will consolidate all your debts into one monthly payment.
This one-time payment is advantageous because the interest rate is generally lower. However, it is possible that your institution refuses you such a loan, precisely because of your high debt ratio which puts off them. If this is the case, a trustee in bankruptcy can offer you other solutions such as the consumer proposal.
The consumer proposal is similar to debt consolidation, but it also reduces the total amount of debt in addition to completely freezing interest. This is a statutory mechanism administered by a trustee to provide you with legal protection. This solution negatively affects the credit record but allows you to get out of the debt cycle once and for all.