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."
