Debt-to-income ratio: What exactly is it?

What is your debt-to-income ratio?

Knowing your debt-to-income ratio is important if you are considering becoming a home owner.  Once you know your ratio, then you need to know what it means and what you can do about improving it.  Let’s get started.

What the heck is a debt-to-income ratio anyway?

Your debt-to-income ratio is the percentage of your annual income (before taxes) needed to cover all your debts, including loans and credit cards.

Why does it matter?

If you’re trying to buy a house, your lender will take this into account before deciding how much to offer you. Additionally, your debt-to-income ratio should be 36 per cent or less in Canada in order for major financial institutions to consider you a low risk.

There are times when money is tight and you may leverage your credit more than usual. Financial institutions will consider you high risk if your debt-to-income ratio is between 37-49 per cent.  You may need to approach a “subprime lender” to get a mortgage. Subprime lenders usually take on more risky borrowers but they also have higher interest rates.

If you’ve been struggling financially and your debt-to-income is 50 per cent or above, consider talking to your lender about restructuring your debt portfolio. It’s never too late to get your finances in order.

How do you improve your ratio?

• Pay down revolving balances as the cash becomes available to you.
• Try not to let unsecured debt rise to a point where you’re paying off debt by incurring other debt. Consolidation loans are great one-time solutions. Do not overuse them!
• Consider using savings or equity in your home to pay off any large unsecured debts. To be more creditworthy, it’s better to have no debt load and no equity than a huge debt load and some equity.
• Avoid or postpone large purchases until you get back on track with your finances.

If you have any questions about your debt-to-income ratio, click here to contact us. You can also click here for a great article from The Globe and Mail by Shelley White.