Na­tal­ie?Brig­gs

Along with your net worth and your month­ly cash flow, your debt ser­vic­ing ra­tio is an­oth­er im­por­tant num­ber that you need to know to as­sess your fi­nan­cial health.Sim­ply put, know­ing your debt ser­vice ra­tio would give you an idea of your abil­i­ty to pay your debts. You would know how much of your in­come is ded­i­cat­ed to debt, ex­pressed as a per­cent­age.

"Debt ser­vic­ing ra­tio, by its very de­f­i­n­i­tion, is the ra­tio of your debts to your in­come," said Win­ston Williams, fi­nan­cial ad­vis­er and Pan Amer­i­can Life agency head, "It is a mea­sure of your abil­i­ty to ser­vice the debt that you have.""That ra­tio is your fixed month­ly debt ex­pens­es over your gross in­come," said Clif­ford Man­choon, founder of the In­creas­ing Wealth Club.

In the past weeks, both men have as­sist­ed Sun­day BG read­ers with learn­ing how to cal­cu­late their net worth as well as their month­ly cash flow. This week they talk about debt ser­vice ra­tio.As in pre­vi­ous ar­ti­cles, Man­choon, has pro­vid­ed a worked ex­am­ple of how to go about fig­ur­ing out your debt ser­vic­ing ra­tio.

"You have the to­tal gross in­come or A, then you have your fixed month­ly ex­pens­es on debt pay­ments or B. These are your mort­gage, your ve­hi­cle, hire pur­chase, cred­it union, cred­it card min­i­mum pay­ment and oth­er loans. When you go down to the bot­tom of the col­umn, you will see that your debt ser­vice ra­tio is B over A mul­ti­plied by 100," ex­plained Man­choon.

Man­choon said most fi­nan­cial ad­vis­ers try to keep their clients around 25 per cent, al­though most banks will is­sue loans to peo­ple with debt ser­vic­ing ra­tios of up to 40 per cent.Williams, how­ev­er, pre­ferred the num­ber go no high­er than 35 per cent and said even this was at the high end of the scale.

"If you have a debt ser­vic­ing ra­tio that is high­er than that, it means that you have stretched your­self too thin. If you have stretched your­self too thin, it means that any bill out­side the norm be­comes cat­a­stroph­ic," he said.

Both ad­vis­ers agree that the key rea­son any­one ap­ply­ing for a loan should know their debt ser­vic­ing ra­tio be­fore they go in­to the in­sti­tu­tion is to save time. Per­sons with a debt ser­vice ra­tio be­tween 35 and 40 per cent are like­ly to be turned down, they say, and the time spent gath­er­ing records to ap­proach fi­nan­cial in­sti­tu­tions and the ac­tu­al ap­point­ment it­self is wast­ed.

"If you are go­ing to get a loan for a mort­gage or a car, you need to look at your to­tal in­come and look at your to­tal debt ser­vic­ing. If that per­cent­age is out­side that rate, then don't even both­er go­ing to the bank for them to turn you down," said Williams.How­ev­er, know­ing your debt ser­vice ra­tio be­fore go­ing to banks is use­ful as it presents an op­por­tu­ni­ty to low­er the num­ber.

Im­prov­ing debt ser­vice ra­tio

The cou­ple in the ex­am­ple pro­vid­ed has a debt ser­vice ra­tio of 43.08 per cent.To get their debt ser­vice ra­tio down to a more ac­cept­able per­cent­age, a fi­nan­cial in­sti­tu­tion may sug­gest debt con­sol­i­da­tion."You lump all the loans in­to one. You get a longer time to pay it off and the in­stall­ment is less. This brings down your debt ser­vic­ing ra­tio," said Man­choon.

But this is not with­out its draw­backs, be­cause even though this one month­ly loan pay­ment is like­ly to bring the debt ser­vic­ing ra­tio back with­in the 35 per cent range it doesn't re­duce the debt amount, it on­ly spreads it over a longer pe­ri­od of time.Williams said this is why, as far as pos­si­ble, loans should be re­strict­ed to big tick­et items, such as a home or car.

He al­so sug­gest­ed a pref­er­ence for cash over cred­it. The Pan Amer­i­can agency head said there was a ten­den­cy for peo­ple whose debt ser­vice ra­tio was al­ready too high to wors­en the sit­u­a­tion by us­ing their cred­it cards to meet month­ly com­mit­ments."It is hard­er to use cash to pay for things than it is to pay for a cred­it card. If I use cash, I would tend to be more con­ser­v­a­tive in my spend­ing than if I can pull out a cred­it card."

Ad­di­tion­al­ly, peo­ple tak­ing ad­van­tage of a debt con­sol­i­da­tion some­times ne­glect to ask for key in­for­ma­tion, said Williams.

"Al­ways ask the bank for two fig­ures, one is the loan pay off amount and the oth­er is the bal­ance on the loan. Most peo­ple don't un­der­stand the dif­fer­ence be­tween the two. There­fore, con­sol­i­da­tion al­ways seems to be a vi­able op­tion. If you find, how­ev­er, that the bal­ance on the loan and the loan pay off amount are the same, it means that all you have paid is in­ter­est. Where­as, if the loan pay off amount and the bal­ance are sig­nif­i­cant­ly dif­fer­ent, con­sol­i­da­tion may make sense."

An­oth­er step to re­duce debt ser­vic­ing ra­tio said Man­choon, was to re­duce ex­pens­es over time or find a way to in­crease gross month­ly in­come."If you are work­ing at a job with a fixed salary, you can't in­crease your in­come as you would like. You would have to look for an­oth­er job or start a side­line busi­ness, to gen­er­ate more in­come," said Man­choon.

Here, a month­ly cash flow state­ment be­comes im­por­tant for pin­point­ing what ex­pens­es can be re­duced or cut com­plete­ly."Try to stick with­in your month­ly cash flow as much as pos­si­ble and to keep your debt ser­vic­ing ra­tio be­low that 35 per cent mark," said Williams, "That is the key to fi­nan­cial suc­cess."

As a mea­sure of how bad­ly peo­ple may be man­ag­ing their debt sit­u­a­tion, Williams said: "Peo­ple are go­ing in­to the bank to ex­tract eq­ui­ty (from their home) for debt con­sol­i­da­tion. So when they were hop­ing to pay off their debt by the time of re­tire­ment, their mort­gage now ex­tends be­yond re­tire­ment be­cause of home eq­ui­ty loans. That is not a good thing."

Man­choon al­so ad­vised po­ten­tial loan ap­pli­cants against "mas­sag­ing facts" to make their chances of be­ing suc­cess­ful bet­ter. He said while a de­nied ap­pli­ca­tion did not hurt them in the long run–par­tic­u­lar­ly if they re­duced their debt ser­vice ra­tio be­fore reap­ply­ing–de­lib­er­ate­ly giv­ing the wrong in­for­ma­tion would hurt their chances giv­en the preva­lence of cred­it and oth­er checks.

"Once the bank re­alis­es you are not be­ing hon­est with them, they will red flag you," said Man­choon.He con­clud­ed that know­ing your debt ser­vic­ing ra­tio puts a pow­er­ful tool in your hand."You could be in charge. You are not de­pend­ing on any­body to write it up for you. You know what to do and you can put things in place."