Just how bad is your debt?

By Dale Jackson 

Shame on us. Statistics Canada says we owe $1.54 for every dollar we earn. Bank of Canada Governor Mark Carney, Federal Finance Minister Jim Flaherty and even the big banks have taken to the pulpit to warn us there will be a reckoning if we don't change our wicked ways.

The household debt-to-income level has shot up dramatically this decade from when it hovered around the 90-cent range in the 1990s. Experts warn if the trend continues, rising interest rates could push our liabilities to unmanageable levels.

But what does that 154 debt-to-income ratio really say about our debt burden as individuals? Not much.

The debt-to-income metric was introduced by StatsCan to provide a big picture view of the combined financial health of Canadian households. It compares total debt (mortgages, car loans, lines of credit and credit card debt) to total annual household disposable income.

But the StatsCan analysis does not included the quality of debt or the different debt scenarios individuals go through at various stages of life.

Different debt for different life stage

Mortgages make up the largest chunk of household debt and rising property values have helped push overall debt higher. A young household with a $200,000 mortgage and annual income of $60,000 would have a debt-to-income ratio of 333 per cent.

Generally, interest rates on mortgages are lower compared to other forms of consumer debt because the property acts as collateral, and payments toward the principal become equity for the homeowner.

At the other end of the scale a $60,000 income household with $30,000 in credit card debt will show a debt-to-income ratio of 50 per cent, but with interest rates ranging from 20 to 30 per cent that debt could be way out of hand.

You can figure out your own debt-to-income ratio by simply dividing household debt by after-tax earnings, and multiply that number by one hundred — but that's just part of your debt picture.

Debt serviceability

While you have a calculator handy, another metric used by the banks to help determine if a borrower can manage debt on a monthly basis is the debt serviceability ratio.

When banks lend money they're not as interested in the total amount as they are in the borrower's ability to make regular payments. From their perspective: the bigger the loan, the longer the amortization period, the bigger the interest payments. These payments provide the bank with a steady revenue stream for years.

When measuring debt serviceability, lenders generally take into account monthly housing costs (principal and interest on mortgage payments) plus property taxes, payments on lines of credit, student loans, credit cards and any other household debt. That number is divided by before-tax household income and multiplied by 100. Lenders generally want that ratio to be below forty.

But what's good for the bank isn't necessarily good for you. Lenders use before-tax income because it really doesn't matter to them if you have enough to pay income tax once they get their cut.

To get a more accurate picture, it's best to create your own debt serviceability ratio by including your net, or after tax income, and subtracting other monthly payments the bank may not consider such as condo fees.

For example, monthly gross income on an annual income of $60,000 is $5,000. Assuming a tax rate of 35 per cent, monthly net income on $60,000 is $3,250 — a $1,750 monthly difference that could spell trouble if borrowing rates increase and you're just making enough to cover your payments now.

For individual households a high debt serviceability ratio isn't necessarily a bad thing if you are paying down debt aggressively and you can handle the payments. Be wary of bankers who entice you in to a longer amortization period by advertising a lower monthly payment.

Debt-To-Asset Ratio

The one thing neither metric considers is household savings. It's almost always best to pay down high interest debt, but with low-rate mortgages it may be better to divert some of those dollars to an RRSP.

StatsCan estimates only four per cent of disposable income went toward savings last year compared with 13 per cent in 1990. That's where the debt-to-asset ratio can tell you where you stand at any point in time and provide benchmarks for your long-term financial goals.

Debt-to-asset measures our net worth — how much we would have, or owe, if we sold everything we own. Put simply, assets minus liabilities.

Assets can be measured in a variety of ways because values can be arbitrary and change quickly. A conservative measure would include the market value of a house and the current market value of all investments. Motor vehicles lose their value quickly but you can include other assets that store value like jewellery or appraised collections. Simply divide household debt by total assets and multiply by one hundred.

Only by saving, will you be saved.