Financial Ratios for Personal Evaluation: Debt to Income Ratio
The main reason I first started Consumerism Commentary was to publicly track my financial progress from “down-and-out” to “not quite as bad.” I started plugging my financial details into Quicken, and like Kara from Ka-Blog says, watching your net worth grow is addictive. There’s more to your finances than just the bottom line, though. I wasn’t aware of this until I started working in financial reporting and studied finance for my master’s degree.
I’ve mentioned financial ratios before. Last time I evaluated my finances using the working capital ratio, which gives me a picture of how well I’ll be able to handle my debt. First, I calculated my working capital ratio for the current month, then went back several months to determine a trend.
Now I’m going to calculate my debt to income ratio. This is another way of determining the health of my level of debt, but rather than comparing that total current debt with my liquid assets, I evaluate my income against my total debt payments (or debt service).
The debt to income ratio is popular in the world of personal finance, and if you ever apply for a mortgage loan, chances are the banks will want to know whether the added debt will require too much of your income.
I first calculated my debt to income ratio for 2006, taking into account the full payments made to my debt, which includes only a car loan and a student loan. Last year I made extra payments to my student loan on several occasions thanks to reimbursement from my company, so those payments are included.
I don’t include my credit card in the calculations because I don’t carry any debt month to month. If I had a credit card balance to pay off over time, I would include my monthly credit card payments in the calculation. The final result for my 2006 debt to income ratio is 0.25 (or 25%).
So is this good compared to the rest of the world? Here’s a guide from U.S. News and World Report:
36% or less: This is a healthy debt load to carry for most people.
37%-42%: Not bad, but start paring debt now before you get in real trouble.
43%-49%: Financial difficulties are probably imminent unless you take immediate action.
50% or more: Get professional help to aggressively reduce debt.
My ratio of 0.25 reflects the average over the entire year. The real test of measuring debt to income is whether the ratio improves over time. I can predict 2007’s debt to income ratio based on the sum of remaining payments due on my car loan, the sum of my expected monthly minimum payments to my student loans during 2007. I’m also using my January income multiplied by 12 to predict my 2007 income. (If this is how 2007 plays out, I’ll be quite satisfied.)
My debt to income ratio will go from 0.25 in 2006 to 0.04 in 2007, assuming I don’t add any debt such as a mortgage.
According to Janet Wickell, the projected ratio puts me in a good position to afford a mortgage, if I were interested. If a lender typically allows 28% of income to be used for housing expenses and 36% of income to be used for housing expenses plus any other debt, I have some wiggle room, again, assuming January proves to be representative of the rest of the year.
Article comments
Matt: My next ratio is the non-discretionary expenses to income ratio, which takes your point into account.
If debt-to-income ratios don’t classify rent as “debt” (which it isn’t) then looking at them is going to provide a misleading picture of one’s financial health, by making the mortgaged purchase of a primary residence look like a far worse decision than it is. I tend to prefer an “obligation-to-income” ratio, which factors in all nondiscretionary recurring cashflows, rather than one which excludes certain ones on the basis of factors other than sustainability. Which change nicely accounts for the fact that substituting a debt service obligation for another form of obligation only worsens one’s financial picture if the latter is larger than the former, and even in that case only to the extent that it is.
Thanks for the comments, Marcus. You raise some interesting points. I was taking the approach of a pure debt to income ratio, but I can see how including rent would produce a better picture if you’re looking to see how much you’re spending in total.
As far as minimum payments go, I don’t see any reason to include them for my own personal analysis. If my credit card decides to change its minimum payment from 2% to 5% of the balance, even though I pay in full every month, and I include that in the calculation, it affects this ratio, even though I’m doing nothing different.
If my payments were based on the minimum amount due each month, then there is a case for inclusion.
This may not be the way lenders evaluate potential customers. What’s useful for lenders isn’t necessarily useful for personal analysis.
I see what you’re saying: using expected debt payments including minimum CC payments shows how well you’ll be able to cover expected liabilities, but I’ve already used the working capital ratio to view that. I’ll also look at an expense/income ratio which will help build a complete picture.
Good post, but I’d suggest a few tweaks –
1.) Most guides – including the US News one you linked to – include rent in your debt calculation. Whether it’s a mortgage or rent, the point is the same: you have to pay money to live somewhere.
2.) You used your extra loan payments and say you would include your credit card payments (if you had any recurring ones). Actually, the way mortgage companies calculate debt ratios is by using your MINIMUM payments.
While your way is inevitably healthier – and further ensures your debt load isn’t just manageable (but can be more easily paid down), it’s not the way ratios are typically calculated.
By using your actual payments, you somewhat contradict yourself — in years you’d pay off MORE debt, your ratio would actually rise (unless your income grew at a higher rate).