What is the debt ratio and how to calculate it?
The debt ratio is an important financial metric both for the economic stability of companies and for your personal finances. Thus, in this article we will explain what exactly the debt ratio is, how it is calculated and how you can use it to have a stable financial life and, finally, we will give you tips to improve your ratio according to your needs.
Definition of the debt ratio
At first, it is key that you understand what exactly this financial concept is. Thus, the debt ratio measures the amount of debt that a person or company has in relation to its total assets or income. Therefore, the calculation of the debt ratio is used to measure the debt and payment capacity of an individual or company.
In personal finance specifically, the debt ratio is a measure of how much debt a person has in relation to his or her total assets. Thus, a high debt ratio indicates that a person has taken on more debt than he or she can pay and is a sign of financial difficulty. Conversely, a good debt ratio will be low and means that the individual is able to pay off all of his or her debts with peace of mind and is financially stable.
It is very important to track your debt ratio to make informed financial decisions. Your debt ratio can give you clues that you need to reduce your debt, reorganize your debt or even increase your income.
How to calculate the debt ratio
In this article we will focus on the calculation of the debt ratio for personal finances, however, the formula is essentially the same for companies. So, first of all, you must be clear about all your monthly payments. The most common ones are your rent or mortgage, insurance, taxes, car and credit card payments, student loans, among others.
Next, you should do the same procedure with all your sources of income, both your salary and any extras you receive, for example, if you rent a room or similar.
It is important that when calculating your debt ratio, you do not include in your expenses those that do not come from debt, such as food, utilities, entertainment, among others. It is a good idea to be clear about the budget you invest in these, however, this is not added in this formula because the purpose is to discover your current indebtedness status.
Once you have the total sum of your indebtedness and your income, you must divide your debts by your income. The result of this operation is your debt ratio.
What is a good debt ratio?
With the result in hand, you can have an effective measure of your financial health. So, although it depends on the specific figure, a figure below 1 is generally considered a good debt ratio. This means that you have more income than debts so you are in a sound financial position.
On the other hand, a bad debt ratio is any number equal to or greater than 1, since, if the number is 1, it implies that you are not making a profit, but that all your income ends up going to pay debts. If the number is greater than 1, your situation is even more precarious because you do not have enough assets to cover all your debts, so you could be at risk of personal bankruptcy. When there are more debts than income, it is very likely that you need to fix your financial situation through new sources of income. Read our article on how to avoid personal bankruptcy here.
Thus, you already know that you must keep your ratio below 1, and the smaller the figure, the better.
How to improve your debt ratio?
Having a good borrowing capacity in Canada is key to being able to meet your financial goals, as it allows you to acquire important loans, when necessary, for example, if you want to move to a new neighborhood or change your car. It is also an indicator that you have achieved financial stability.
Thus, we give you the best tips to improve your debt ratio so you can get better interest rates on all the loans and credit cards you apply for, as well as increase your credit score.
First of all, it is a good idea to take care of those high interest debts first as they are the most detrimental to your personal finances. So, our advice: if you are having difficulty paying your liabilities, you should prioritize the high-interest ones.
Secondly, another common tip for people with high levels of debt in Canada is to consolidate your debts. This allows you to reduce the amount of interest and makes it easier to manage your payments. A great option is to apply for a personal loan in order to consolidate your debt, so these usually have much lower interest rates than, for example, a credit card. Here you can read our article on debt consolidation.
Another recommendation is that, as far as possible, try to make more than the minimum payment when you take care of your debts. This way, you will be able to pay them off more quickly, reduce interest and improve your debt ratio.
If you deem it necessary, you can also increase your sources of income, either through freelance work or selling second-hand items that you no longer want. Remember, even if you get more assets, you should still create a budget and manage your finances to make sure you are managing your money properly.
Finally, it is best to avoid incurring new debts, especially credit cards, as these become a quick way to spend funds you don’t have and, in addition, have high interest rates. On the other hand, the only loan we recommend is a personal loan to pay off your high-interest debts. If you are looking for a personal loan to improve your rate of indebtedness in Quebec, we recommend Mon Petit Prêt, who have low interest rates and easy payment terms.
As you have seen, improving your debt ratio can be beneficial in many ways. Following these tips can help you pay off your debts faster and have good financial health. For more personal finance tips, you can read our blog here. Also, if you have decided to take out a personal loan, you can apply for one here.