Debt ratio refers to the percentage of debt against a person's assets. There are several ways to measure debt ratio when it comes to managing personal finances. These calculations are useful when determining how much extra debt, such as mortgages and car loans, can be afforded. In the bigger picture, the average financial ratio of an entire population is a reliable indicator of a country's economic health.
The debt-to-income ratio shows the percentage of income that goes toward paying off debt. There are two ways to calculate this ratio: either with or without mortgage. Simply add up the total debt, including loans, credit lines and credit cards and divide that number by the after-tax income. Afterward, repeat the formula with mortgage included in the debt. For example, if a person makes $1,000 per month and must pay $300 in bills and $200 in monthly mortgage payments, the income-to-debt ratio is 30 percent excluding mortgage and 50 percent including mortgage.
Banks and mortgage lenders use the debt-to-income ratio to determine how much money they should lend to an applicant. In most cases, lenders would not approve a mortgage loan if the ratio exceeds 36 percent. For example, if a person makes $1,000 per month, his monthly bills should not exceed $360. If it does, then the person would not qualify for a mortgage. Not all lenders abide by this rule. Keep in mind, though, that by lending to applicants with high debt-to-income ratios, a lender is also taking on more risk and would typically offset the risk by offering higher mortgage rates and fees.
How Much is too Much?
A healthy debt-to-income ratio should be no more than 10 percent excluding mortgage and 36 percent including mortgage, according to America’s Debt Help Organization. When debt payment exceeds 36 percent of the take-home salary, it may easily become unmanageable. A person with a debt-to-income ratio higher than 40 percent is considered risky, according to Dejardins, meaning lenders would not approve lending student loans, mortgages or car loans to that person.
Another financial ratio is calculated by subtracting a person's total debts from his total assets. This calculation produces the net worth of an individual. A negative number means there are more debts than assets. It may be useful to track the net worth year by year in order to manage personal finances and alter spending habits as required.
- Hemera Technologies/AbleStock.com/Getty Images