You often read in the media that the average Canadian has a debt-to-income ratio (DTI) of around 176%. Statistics Canada monitors the financial health of consumer households with this ratio. For their purposes, they use total household credit (including all mortgages, credit card debt, bank loans, and other consumer debt) to annual disposable income. Using total debt rather than monthly debt payments is why this number is so high. For the economy, the number itself is not important, it’s the overall trend, and the average Canadian debt-to-income ratio has been on the rise.
So how do you know if you have too much debt to handle? What is a recommended or acceptable debt-to-income ratio for an individual?
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What is a debt-to-income ratio?
Your debt-to-income ratio (DTI) tells you how affordable your debt repayment is. It can help you decide if you have too much debt or if you can manage your debt payments comfortably.
To calculate your debt-to-income ratio, add up all your monthly debt payments, and divide this by your monthly gross income. To express your ratio in percentage form, multiply it by 100.
As a formula: DTI = monthly debt payments ÷ monthly gross income x 100
Let’s use the 2018 average Canadian total income of $4,000 a month ($48,000 a year) as an example. Let’s also say that your overall total monthly debt commitment is $1,800.
Doing the math, that would be $1,800 divided by $4,000, with the result being 0.45. Now, multiply that 0.45 by 100 (to have your DTI come out as a percentage). The final answer, which is 45%, is your debt-to-income ratio.
To calculate the share of your income consumed by debt repayment, try our easy-to-use debt-to-income ratio calculator.
What is included in your DTI?
The debt-to-income ratio compares how much you owe versus how much you make. If you want a good representation of your financial situation, you want to include everything meaningful to the outcome.
Debt payments to include
You need to sum up your monthly debt payments first, including all types of loans you carry. These should include items like your mortgage payment or rent, car loan, credit card payments, personal loans, student loans, and payday loans. Some people include child support and alimony payments as well, while others consider this to be a monthly expense. If you are struggling with support payments, we recommend adding them as you want a full picture of your risk of default on recurring financial obligations.
What income to include?
Once you’ve added up all your debt payments, you need to divide them by your monthly gross income (MGI). This is the total amount of money you make every month before taxes.
Your gross income is different from your take-home pay or net income, which have taxes deducted. Gross income also still includes the amount that you’d pay towards any employment insurance, Canada Pension Plan (or Quebec Pension Plan), and any benefit deductions by your employer.
Include all income sources, including employment income, pension income, government benefits, student grants, support payments received, etc.
Self-employed contractors should include gross income less business operating costs but before any personal taxes.
If your income is variable, take your annual income and divide by twelve. Estimate on the low side, excluding any bonuses or commissions you may not earn.
What is an acceptable level of debt at your income level?
Most people we meet carry a lot of debt like credit card debt or lines of credit that only require a minimum payment each month. Minimum payments are never enough to get you out of debt. In fact, they are designed by the banks to keep you in debt. Our recommended ratio limits reflect this type of bad debt. If you are paying more than the minimum on your credit cards, good job. You can adjust the sensitivity of our recommendations a little to your benefit.
Based on our experience, here is what your debt repayment ratio can mean:
30% or less: You are probably OK. Debt repayment is not consuming a significant amount of your monthly pay, leaving you room to increase your payments enough to pay off your debts on your own. Using the tools in my last email, build your budget, create a repayment plan, stick with that plan and you will likely find yourself in much better shape within a year.
31% to 42%: While you may be able to manage with a debt repayment ratio this high, you are at the maximum range of acceptable. If a significant number of your debts have variable rate interest (like lines of credit) start working to reduce your debt now as rising interest rates will mean more of your paycheque will be going towards debt repayment in the future. If you are only making minimum payments, next month keep your payments the same. Having a higher, fixed, monthly payment, will help you get out of debt sooner.
43% to 49%: This is cause for concern. Any variation in income or interest can put you in the danger zone. If you only included minimum payments, you may not have enough room in your income to increase your payments enough to pay off your non-mortgage debts. We help many people with debts in this range make a successful proposal for partial repayment to their creditors.
50% or higher: Dangerous. If debt repayment is taking up more than 50% of your paycheque, you are facing a debt crisis that you probably can’t deal with on your own. It’s time to talk about options for debt forgiveness, so you can lower your monthly payment to a much more affordable level.
Importance of knowing your debt-to-income ratio
While your debt-to-income ratio does not affect your credit score, it is another measure lenders use when deciding to extend credit.
Credit scores assess payment and credit history and a person’s current borrowing portfolio and credit utilization ratio. A debt-to-income ratio helps lenders gauge if a borrower can afford higher monthly payments when taking on new debt. The reason is that consumers with a higher DTI ratio are more likely to default.
In other words, credit scores measure creditworthiness, and debt-to-income measures affordability.
Another ratio you should monitor when it comes to credit cards is your debt-to-credit limit. Your debt-to-limit calculation is your credit card outstanding balances divided by your credit card limits. Keeping this ratio below 30% at all times is better for your credit score.
A mortgage lender use two related income ratios to determine if your potential mortgage is affordable: Gross Debt Service (GDS) and Total Debt Service (TDS) ratio.
GDS looks at your total housing costs (including your mortgage payment, insurance, heating costs, property taxes, and condo fees) as a percentage of your gross income. They recommend your GDS not exceed 35%. TDS adds non-mortgage debt repayments to the calculation and should not exceed 43%.
Including a broader range of housing costs, is the most conservative way to measure your DTI.
Financial or insolvency risk
There is also a strong link between over-indebtedness and elevated risks of financial shocks.
From an individual’s perspective, such shocks come from unexpected life events. It’s common for people to be able to handle their debt payments until they lose a job or have their finances stretched thin through a divorce or a severe health condition. Unexpected events, when combined with high debt levels, are the most common causes of bankruptcy.
Help you prioritize debt repayment and savings
Too high a debt load isn’t just about keeping up with your monthly payments. The more debt you have, the less you can save.
A lower debt ratio would mean having more disposable income. This, in turn, gives you more chances of saving up and building an emergency fund.
How to bring your debt-to-income ratio down to an acceptable range
The first step is to build a debt repayment plan. Make a list of your debts and rank them from highest rate to lowest rate.
Next, check which lenders allow early repayments without penalties. Contact your loan provider to find out if they have a cap for prepayments. Then, every time there’s room in your budget, make the maximum (if there’s any) prepayment on those loans.
I recommend paying down high-interest debt first. The bigger your repayments towards these debts, the less interest you pay. Just make sure that you also keep making at least the minimum payments towards your other loans.
If you don’t have loans with sky-high rates, you can also prioritize paying off the smallest one first. Once you get rid of that debt, move on to the next one with the lowest total debt amount. Keep working your way up until you erase all of your debts.
Aside from paying off your existing debts, here are other ways that can help reduce your DTI.
- Avoid taking on more debt
- Transfer some of your debts to a low-rate loan or credit card, so your payments go further towards principal reduction
- Use any extra income or budget savings to make more significant payments towards your debt
- Make small micropayments throughout the month to help avoid late fees and lower interest costs
What to do if your debt ratio is too high
I meet with people every day who have built themselves a plan to pay off their debt, then failed because of one common thing they didn’t know ahead of time – their monthly debt obligations were too massive to repay on their own, even with their best efforts.
If your existing debt is too high, you may need to consider these debt relief options:
Consider getting into a debt management plan (DMP)
A debt management plan is a repayment program managed by a credit counselling agency. It involves the consolidation of unsecured debts into a single, easier-to-manage monthly payment. A DMP is different from a debt consolidation loan, however, in that it’s not a new loan.
While enrolled in a DMP, you’ll still owe each original lender. However, you’ll enjoy much lower or no interest rates on debts included in the program.
A DMP will have an extra fee amounting to about 10% of your total debts. A potential drawback to a DMP is that it may not be able to consolidate all the loans you carry.
Explore your debt consolidation options
Unlike debt management plans, debt consolidation involves taking on an entirely new loan. You’ll work with a new lender who’ll issue funds that you’ll then use to pay off multiple debts.
Debt consolidation loans should provide a lower interest rate and monthly payment amounts.
Speak to a Licensed Insolvency Trustee
Licensed Insolvency Trustees (LITs) are professionals regulated by the federal government to help people manage overwhelming debt.
If you’re concerned about your debt, we’d be happy to talk with you about your situation and how a consumer proposal or bankruptcy can help you eliminate overwhelming debt.