Before You Get Debt Help, Should You Use a Debt Ratio, Debt-to-Equity Ratio, or Debt Calculator?
When you need debt help, a debt calculator that illustrates various repayment scenarios, along with how much time each one takes and how much each one will cost, can help you determine the best way to deal with your debts. When it comes to personal finance topics in Canada, a debt ratio calculation is simply a comparison between how much money you owe and your gross (before tax) income. A debt-to-equity ratio is comparing how much you owe (your liabilities) to what you own (your assets).
But can knowing your ratios help you determine how best to deal with your money problems?
Is Knowing Your Debt Ratio Important?
While many people understand how a debt ratio is calculated, it can be much harder to appreciate what it means for your budget, overall financial picture, or how it affects your ability to borrow in the future. Knowing your debt ratio is most important if you want to borrow money, but much less important if you need help to deal with your debts. For daily money management or balancing your household budget, knowing how to spend less than you earn is more important than knowing the actual ratio; if there’s more month than money, no ratio will help.
When is Your Debt Ratio Used?
When you want to borrow money from your bank, credit union or other lender, depending on why you’re borrowing the money will determine which debt ratio calculations matter. With consumer borrowing in Canada – that means people applying for loans, mortgages, lines of credit, credit cards and other forms of credit, there are typically two kinds of debt ratios that come into play; TDSR, which stands for total debt service ratio; and GDSR, which is gross debt service ratio.
What is a TDSR and When is it Used?
A TDSR, or total debt service ratio, calculation is used when you want to borrow money. It takes into account all of your current consumer debt payments, e.g. personal loans, overdraft, line of credit, student loan, credit card and cell phone on contract. Expenses like food, parking or daycare costs are not included. In some cases, a lender includes what the minimum payments would be if you used all of your available credit. (This means that if you have credit cards with high limits that you aren’t using, they could impact your ability to borrow in the future.) Then it compares your total monthly debt/credit payments to your gross monthly income.
A percentage of less than 39% is ideal. If your TDSR is between 39% – 44%, a traditional lender may still be able to approve a loan for you, depending on your overall situation. A TDSR of 44% or more means that you have a definite cash flow problem and that you may not be in a position to honour your current payments. It could be unwise to lend you more money because the likelihood of you being able to repay it might be questionable.
What is a GDSR and When is it Used?
A GDSR, or gross debt service ratio, is used when you’re applying for a mortgage. It is an additional calculation a lender performs. The obligations that are taken into account for a GDSR calculation are principal, interest, property taxes, heat and strata (if what you’re buying has strata payments). The total is then compared against your gross income and the resulting ratio, the GDSR, can not exceed 32%. This means that banks will not lend you money if the cost of owning your home exceeds 32% of your income.
Can You Borrow Money if Your Ratios Are Higher?
While there are lenders who will allow your GDS and TDS to go beyond the normal guidelines, they will charge you more for taking on the risk of lending someone with high expenses more money. When your ratios are higher than normal, you might not truly be able to afford the new loan or mortgage payments. This can cause a stressful situation for you as well as your lender, so it is best to avoid knowingly getting in over your head.
What is Debt to Equity Ratio?
Debt to equity ratio is a calculation that is used to determine someone’s net worth, but it isn’t the best calculation to focus on when you need debt help. Net worth is how much someone owes compared to the value of their assets. Many people think that a good net worth means qualifying for a big mortgage or having a lot of gold credit cards. Net worth, however, doesn’t tell the whole story.
Why Net Worth Doesn’t Tell the Whole Story
Think about this net worth example: household A has no credit card or personal debt, a little bit of emergency savings and some RRSP savings, they drive 10 year old cars that are well maintained and long since paid off, and they have paid off two-thirds of the mortgage on their modest home, versus household B who owns a beautiful million dollar home, has a near million dollar mortgage, very little savings, two new luxury cars with car loans at 0% interest, and lots of credit card debt that they make minimum monthly payments on – which household has the better net worth?
All that glitters definitely isn’t gold. When you compare the amount of debt to how much equity household B has, they might actually end up in a negative net worth position, owing more than the value of their assets. Household A, while they have a modest home and what might be described as a frugal lifestyle, the value of their assets out-weighs how much they owe. They have a better net worth.
Using a Debt Calculator
Ratios and net worth aside, a debt calculator
is what might provide the help you need to really get a good grasp of how best to deal with your debts. A debt calculator will take what you owe, what your payments and interest rate are, as well as the terms and conditions of your debts (e.g. interest is calculated slightly differently on credit cards versus a line of credit), and show you how to save time and money. By creating an effective debt repayment plan
using the information from a debt calculator, you can strategically tackle your debt, one payment at a time.
Ratios and Calculators Don’t Solve Money & Debt Problems – Get Real Debt Help
Dealing with your money and debt problems needs more than ratios and calculators. To find good options and solutions, you need information and guidance from professionally qualified and certified Credit Counsellors. Contact us now by phone
or anonymous online chat
to find out more and ask us your questions. Letting us provide you with information and guidance is free and without any obligation. We’re friendly and happy to help you.