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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