What are debt ratios?
Have you been turned down for a loan because you’ve been told that your debt ratio is too high? Do you know what that means exactly?
What is a debt to income ratio?
This is a term you’ll hear commonly when applying for a loan. This is a calculation that lenders take to evaluate your take-home pay in relation to your debts. It helps them assess how much of a perceived risk it is to lend to you. Simply, the higher that your debt to income ratio is, the harder it might be for you to be able to afford your debt payments. That’s why lenders prefer your debt to income ratio to be on the lower side.
If you’ve had credit problems in the past, are self-employed or are new on your job, your lender might even make it a requirement that your debt to income ratio be even lower. Typically, the absolute maximum ratio you can have to qualify for a credit product is 40 per cent. Ideally, you should be well below that (36 per cent or less).
“Obviously when it comes to how much of your income is going to pay for debts, less is more. The lower this ratio, the less financially vulnerable you are,” says Jeff Schwartz, executive director, Consolidated Credit Counseling Services of Canada.
What is a debt service ratio?
Your debt to income ratio will figure into your debt service ratio. Your debt service ratio can be evaluated in two ways: the Gross Debt Service ratio (GDS) and the Total Debt Service ratio (TDS). These ratios help determine how much lenders will give you as a maximum amount.
The GDS addresses your mortgage/rent payments, property taxes (if applicable), heating costs and 50 per cent of condo fees (if applicable). The GDS helps lenders evaluate how much it would cost for you to own a specific property based on your income. Usually, this ratio needs to be below 32 per cent.
The TDS takes the payments for “costs of living” (i.e. shelter) and also includes payments for debts (i.e. loans, credit cards, lines of credit, etc.). Your TDS is similar to your debt to income ratio and shouldn’t exceed 40 per cent.
What is a debt equity ratio?
A debt equity ratio (also known as the debt to asset ratio) is similar to your debt to income ratio in that it measures your debt load and your credit worthiness from a lender’s point of view; it is used most often when you are applying for a mortgage loan. This criteria looks at how much debt you are taking out against how much equity you’ve got in your home.
“It is preferable to have more equity than debt tied to your asset. You can tip this ratio in your favour by reducing the amount of mortgage that you take out, either by choosing a less expensive home or increasing your down payment,” says Schwartz.
High ratio borrowers (i.e. those with less than 20 per cent of a home’s assessed value put down in cash) are required to get mortgage insurance, which is an indication of the increase in risk – both to the lender and to your personal finances.
Had credit problems in your past? Ready to get back on your feet? Get the ball rolling by reducing your debt load so that your debt to income ratio can be lower. Call one of our trained credit counsellors at 1-888-294-3130 or get started with our online debt analysis.