Debt is an unavoidable part of modern life. It enables us to purchase goods and services beyond our immediate means, such as a car, a home, or an education. But with debt comes the responsibility for repayment, and the challenge of managing various forms of debt can be overwhelming. One piece of data that can provide clarity and assistance in navigating personal debt is the debt ratio. This article will explain what a debt ratio is, why it’s important, and how to calculate it. We’ll also explore how to interpret the results of this calculation and how to utilize this information to improve personal financial health.
What is a Debt Ratio?
A debt ratio is a financial metric that expresses the level of debt in proportion to another variable, typically income or assets. It’s a way of gauging the amount of money owed relative to a borrower’s financial circumstances. Specifically, a debt ratio measures the percentage of a borrower’s monthly income or assets that are used to cover debt payments.
The two primary types of debt ratios commonly used in personal finance are the debt-to-income (DTI) ratio and the debt-to-asset (DTA) ratio. The debt-to-income ratio measures the proportion of pre-tax income that goes towards paying monthly minimum debt obligations. The debt-to-asset ratio, on the other hand, compares the total debt amount to the total amount of assets held by an individual.
Why is a Debt Ratio Important?
Calculating your debt ratio can provide valuable insight into your overall financial health, particularly in regards to debt management. Carefully managing the amount of debt you take on and your monthly debt payments can help you avoid financial difficulties that can result from over-extended payments and obligations.
Perhaps one of the most significant reasons to keep an eye on your debt ratio is that it can signal if a person is maintaining a healthy balance of income, debt, and assets. If the debt ratio is too high, it may indicate that a borrower is overly leveraged, meaning that they have taken on too much debt in relation to their income, and may be at risk of default, overlooking more significant expenses, or having trouble covering routine expenses, like rent or groceries.
Conversely, if the debt ratio is too low, it may indicate that the borrower is not taking advantage of opportunities to build credit. Ensuring that you maintain a healthy balance of debt to income and other assets can help to improve your credit score which can translate to more opportunities to access advantageous loans and other financial products.
How to Calculate a Debt Ratio
Calculating your debt ratio is simple and involves some basic arithmetic. For the debt-to-income calculation, take your total monthly debt payments and divide them by your pre-tax monthly income. Then multiply the number by 100 to express as a percentage.
For example, if your pre-tax monthly income is $2,500, and your monthly debt obligation is $500, you would divide $500 by $2,500, which equals 0.2. When multiplying by 100, your debt ratio would be 20%.
The calculation for the debt-to-asset ratio is a little different. In this case, divide your total debt amount by the total amount of assets you hold. This calculation provides a percentage and represents how much of your assets are entangled in debt.
For example, let’s say you have $10,000 in debt and $20,000 in assets. You would divide $10,000 by $20,000, which gives you 0.5. When multiplied by 100, this would equal a debt ratio of 50%.
How to Interpret Your Debt Ratio Numbers
Now that we understand how to calculate our debt ratios, let’s explore how to interpret the results.
Your personal interpretations of your results will depend on the specific numbers and context. However, as a general rule of thumb, a debt ratio of 36% or less is generally considered favorable. The 36% threshold is based on guidelines used by lenders when assessing a potential borrower’s level of acceptable risk. This means that in general, if your debt-to-income ratio is below the 36% threshold, lenders—who typically use 36% as a benchmark for creditworthiness– are more likely to approve you for a loan or credit product.
If your debt ratio falls between 36% and 50%, you’re considered overleveraged. Borrowers with a debt-to-income ratio above 36% and below 50% are not considered high-risk, but lenders may require extra documentation, such as proof of income, to extend credit.
It’s important to note that any debt ratio above 50% is considered a warning sign. If you have a debt ratio above 50%, it’s best to investigate to find ways to reduce debt obligations or look for opportunities to increase income in a sustainable manner.
Tips for Improving Your Debt Ratio
If you’ve calculated your debt ratio and found it’s a bit higher than you would like, don’t worry! There are several strategies you can use to help improve your debt ratios and your overall financial health.
1. Reduce your monthly minimum payments.
One strategy to help improve your debt ratio is to identify opportunities to reduce your monthly debt payments. This may involve consolidating your debt, refinancing existing high-interest loans, or negotiating with creditors to devise a loan repayment plan.
2. Review your Budget
If your current budget can’t accommodate with these reductions, try re-prioritizing your expenses or increasing your income in a sustainable manner.
3. Increase your income
Increasing your income is a great way to help improve your debt ratio and your creditworthiness. You could consider taking on a side job or finding new opportunities to increase your earning potential in your current career.
4. Develop a budgeting plan
Creating and sticking to a budget can help you manage your debt ratio more effectively. It can help you identify where you can cut expenses and restrict areas of unnecessary spending.
As you can see, debt ratios are important tools that can assist you with managing your debt obligations and improving your overall financial health. Understanding your specific debt ratio numbers in relation to established industry benchmarks and practice guidelines is an excellent first step towards maintaining a manageable level of debt, optimizing your creditworthiness, and achieving your financial goals. By regularly monitoring your debt ratio, you can make important decisions and changes that will help you to achieve financial security and independence. With a few simple changes and a bit of discipline, you can take steps towards financial responsibility and long-term success.