Why Our Debt To Income Ratio Is Misleading

Much has been said about the current state of Canadian household debt.  The latest numbers from Statistics Canada revealed our debt-to-income ratio is now a record 164.6%.

But what does this number really mean?

In simple terms, you add up everything you owe – your mortgage, line of credit, car loan, credit cards and student loans – and divide the total by your annual after-tax household income.  Multiply by 100 and you have your personal debt-to-income ratio.

Related: Home Equity Line Of Credit – Friend Or Foe?

Your Debt To Income Ratio

The median after-tax income for families of two or more people is about $66,000.  I don’t know the median debt-to-income ratio, but if you take the average of 164.6% that means Canadians who earn $66,000 a year after-tax have about $108,000 in debt.

There’s a good chance that your debt-to-income ratio is much higher than the average if you’re young and just starting to get your finances together.  In fact, if you’ve recently taken out a mortgage, it’s likely you owe more than two or three times your annual after-tax income.

Mortgage Debt Is Not Consumer Debt

Should you be worried?  If the bulk of your debt is from credit cards and high interest loans, then yes, you need a plan to pay off your debts as quickly as possible.  Too many of us our financing our lifestyle; borrowing to spend on cars, furniture, gadgets, and vacations.

Related: What Is Your Real Hourly Wage?

Mortgage debt is another story.  Rates are at historic lows and they’re likely to stay low for several years.  It’s also difficult to compare annual household income with low interest mortgage debt that’s designed to be paid off over a long period of time – up to 25 years.

A better ratio to look at is your debt service ratio; your monthly mortgage or rent payment plus your total debt payments divided by your monthly after-tax income.

Aim to keep your total debt service ratio under 40%.  If you’re the median Canadian household who brings home $5,500 a month, you should keep your monthly debt payments under $2,200.  This sounds pretty reasonable.

Related: How Much House Can I Afford?

Your goal is to keep life affordable.  You could be consumer debt free yet still strapped for cash every month because you bought too much house.  Or you could be blowing all your money on two car payments and not have enough to save for a rainy day.  Not ideal scenarios.

Stress Test Your Finances

The rising debt-to-income ratio makes for splashy headlines, but all it means is wages have been flat for a few years while cheap borrowing rates fueled a huge increase in low interest mortgage debt.

Look at your personal debt service ratio to determine the state of your household finances.  Pay off your consumer debt and get started on a regular savings plan.

Then you should put your finances under a stress test to see how well you’d cope with an economic shock, like a job loss or a big spike in interest rates.

Related: Why Do We Save?

That means increasing your cash flow so you can handle a higher mortgage payment when it comes time to renew your term.  It also means building a cash stash that can cover your expenses for a few months if find yourself out of a job.

Final Thoughts

Our debt-to-income ratio is about 200%, which is much more than the average Canadian household.  That’s because we just bought a new house and took on a big mortgage.

The mortgage is our only debt, however, and we plan to pay it off in 10 years.  Even with our accelerated payments our total debt service ratio comes in at about 22%, well under the optimum percentage that banks look for when they lend money.

Related: Should You Pay Off Your Mortgage Early?

The debt-to-income ratio is used way too often to scare Canadians into paying off their debts, but the statistic is misleading.

Canadian household debt is a concern, but we’re using the wrong metric to gauge our financial health.

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  1. Liquid on January 7, 2013 at 12:20 am

    Great points about how misleading these numbers can be without understanding what they really mean. My debt to income ratio is about 600%, but even if interest rates were twice as high as they are today I would still have no problem making all my payments. But I have to pay down my debts quickly now before interest rates start to rise :0)

  2. VanIsle Retiree on January 7, 2013 at 10:47 am

    With the currently very low interest rates on mortgages, maybe more people should be thinking about minimizing their mortgage payments right now, using the extra money to own something that makes money (good quality preferred shares, REITS, etc), then take that extra earned income to pay down their mortgage when it comes up for renewal at what will inevitably be a rather higher rate. Why would we try to pay down a mortgage at a little over 3% when you can readily make 6% on that same money!! The logic of getting rid of the mortgage comes from people of my vintage, but it is not so appropriate with such low interest rates right now. But no question, you should get rid of that credit card debt ASAP.

  3. Money Beagle on January 7, 2013 at 11:54 am

    I don’t track this but I do track our debt-to-equity ratio, meaning how much of our total assets is (oops, my typing was just interrupted, annoying popups)
    ours and how much is owned by someone else. A number of zero means you have no debt. A number greater than 100% means that you have a negative net worth. Somewhere in between is where most people lie. I think tracking this important as well though I’ve barely seen mention of. Sounds like I have a post idea!

    • Potato on January 13, 2013 at 9:27 pm

      The debt-to-equity (or debt-to-assets) ratio isn’t normally tracked because it’s not as useful except on a case-by-case basis. So tracking your own is fine, but a population measure of it wouldn’t give the same measure of risk, in part because asset values can change while the debt remains, and in part because debt has to be serviced by income.

  4. Joe on January 7, 2013 at 12:19 pm

    I think you’re right on an individual level — that people should be extremely worried or not particularly concerned based on the composition of their debt (whether it’s all low-interest mortgage debt or includes a lot of credit card/HELOC debt or debt like student loans that can’t be discharged by bankruptcy).

    But on a macro level, now that our economy has the same levels of debt seen in the US before their economy completely imploded, I think we should be very, very worried, especially when a ton of that “OK” debt is high-ratio mortgage debt (which could very quickly be under water).

  5. Jane Savers@ The Money Puzzle on January 7, 2013 at 2:17 pm

    My debt to income ratio is 61.5%. All HELOC debt.

    My debt service ratio is 25%. That may seem good but it means I will be in my early 50s before my debt disappears and I can start to shift the debt repayment money to retirement savings.

    Debt is stressful even when interest rates are low.

  6. Anne @ Unique Gifter on January 7, 2013 at 2:42 pm

    The ratio used completely depends on the scenario, I think, in order to provide information of worth. The last thing I read said the average Canadian household has 114K worth of debt. To use the 164.4% would mean my household would have more than double our current debt load. Whew, so glad that we’re below that average and more in line with the 114K, while at the same time we are rather young.
    I am more interested in consumer debt values myself, plus a separate mortgage to earnings ratio. I feel the two offer rather different pictures and a more complete picture when viewed together.
    Most loans require a GDSR below 40 or 42%, depending on the value. That said, that is eating up a whole lot of income, depending on income level.

  7. Adina J on January 7, 2013 at 5:14 pm

    We are essentially in the same boat as you, with respect to our debt-to-income ratio (and its cause). I think that having a mortgage that’s roughly two times your annual income is considered a pretty safe bet when it comes to house ownership. In fact, we’re lucky enough to have an income that allows us to buy our “forever” house at that kind of ratio (and not the 3, 4 and 5x annual income that most people have to contend with).

  8. Guy Souriandt on February 21, 2013 at 1:30 pm

    The debt to income ratio is important at the national level. It measures how much income Canadians generate to pay off their debt. High debt to income ratios were the root cause of the 2008 housing melt down and recession in the U.S. Because their debt got to high relative to their income and ability to pay the debt, people defaulted on loans; housing prices crashed as people liquidated to pay off creditors. That meant fewer people spending money on new homes and consumer goods, and a recession that drove down incomes even further.

    It could happen in Canada. We’ve now exceeded the debt-income ratio of Britain and the U.S. before their housing meltdown. Unless Canadians start paying down debt or getting higher salaries, a recession, and increase in joblessness, salary cuts, cut sin government spending, or an increase in interest rates could all trigger a meltdown.

  9. Denis on December 27, 2013 at 9:27 am

    When people think I am paying 3% on my mortgage so why should I not invest extra money at 6% they are neglecting one thing.

    Risk. People do not account for risk! That job you have can be gone in a heartbeat. Injury, the need to take continual care of a spouse, the kid wrapping the car around the neighbor’s front deck while DUI are all things we do not expect to happen, but they do. That great income is what sustains that ability to pay the mortgage. If it is gone, the stuff hits the fan quickly!

    If you have a fully paid for house, invest all you want. But until that debt is cleared, think of it as the proverbial hammer about to fall off the roof onto your unprotected head! Don’t let Bad Luck Murphy live in your spare bedroom!

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