Understanding debt-to-income ratio

The debt-to-income ratio is a common headline story; for a long time, it has been reported that the number is very high and ever increasing. So what is this ratio, why is it rising, and most importantly, what does it mean for you personally?

What is debt-to-income ratio?

The debt-to-income ratio is a measure of how much debt, including mortgage, car loan(s), credit card(s), a household is carrying relative to its disposable income; that is net income, after taxes, CPP and EI deductions, are made.

In Q2 2021, Statistics Canada reported a ratio of 173.08 percent, which means that, across all Canadian households, in the second three months of 2021, we collectively owed $1.73 for every dollar of disposable income we had. That is very close to the all-time high of 179 percent in late 2017. This number was high enough to land Canada in the upper quartile of countries among the OCED (9^th out of 38).

The debt-service ratio, or the cost to service the at debt, is 13.32 percent, which means that, across all Canadian households, of every dollar in disposable income, 13 cents is used to make payments to service the debts, or make payments on debts as they become due.

How did we get here?

While the debt-to-income ratio is important, what really matters is not the total amount borrowed, but the cost to service that debt over time — the debt-service ratio. The lower the interest rate, the cheaper it is to borrow money and service that debt, and therefore, the more debt a household can afford to carry. Over time, the debt-service ratio has remained constant even as the household debt-to-income ratio has risen.

For example, in 1990, the debt-to-income ratio in Canada was a mere 86 percent, or $0.86 owed for every dollar of disposable income.

However, at that time, the average interest rate on a five-year mortgage was 14.31 percent, where the average interest rate on a five-year mortgage is currently 4.79 percent. In practical terms, $100 borrowed for a year at the 1990 rate would cost three times as much to service as it would be if borrowed today.

This incredible drop in interest rates accounts for why the debt-service ratio has remained steady over time, fluctuating between 12 percent and 15 percent from 1990 to now.

Over time, we have become more accepting of borrowing as a normal part of household finances. When the ability to borrow became a tool to “buy now pay later” in our household spending, most of us decided to do so. With the cost of borrowing gradually dropping, we have increased our debts.

How does debt-to-income ratio matter?

The general consensus is that excessive levels of debt make households financially vulnerable. If applied to Canada, it would make the economy less resilient to future shocks.

Economic shocks are sudden and unpredictable changes which affect the overall economy. On an individual level, the same shocks would be unexpected changes to your household’s financial situation, such as unemployment, marital breakdown, illness, or increases in interest rates, which means you cannot make your mortgage, student loan, or car payments.

The debt-to-income figure represents an average for all Canadian households, including those who have little or no debt — meaning it must also include some very highly indebted Canadians. The more debt you have, the more vulnerable you are to “shocks” that can impact your ability to repay it.

If you owe a lot of debts, it impacts your eligibility to take on more debts, especially important ones like a mortgage. According to Canada Mortgage and Housing Corporation (CMHC), if your household’s monthly housing costs (mortgage payments, heating/hydro, property taxes) plus monthly debt servicing costs (credit cards, car loans) exceeds 44 percent of your gross monthly household income, it will make you ineligible for an insured mortgage (where the down payment for the purchase of the home is less than 20 percent).

If you want to maximize your financial peace of mind and protect yourself from the risk of being unable to meet your debt obligations over time, you should minimize borrowing while prioritizing paying back any existing debts. This will enable you and your family to reach financial milestones, even major ones like purchasing a home. A Licensed Insolvency Trustee (LIT) can offer expert advice by reviewing your financial situation and goals and recommend options to deal with your outstanding debts, so that you can achieve those important family goals.