Flawed and Unreliable
I want to know who’s daft idea it was to make the debt to disposable income (DTI) ratio the most widely used and talked about metric to determine our financial risk. “Debt” is a balance sheet item (net worth,) but “income” deals with budgeting or income statements. Debt is simply a static number. But income requires the element of time in order to exist. One has a set monetary value while the other is a reoccurring event. Comparing the ratio of debt to income is like comparing net worth to spending. Or, for the engineers out there, like comparing a scaler against a vector. The two parts that make up the ratio are loosely correlated at best, but it’s not a very relevant measurement for any practical purpose. And why is the income represented as an annual rate? Why not monthly?
The other problem with this ratio is it’s heavily influenced by monetary policy. 30 years ago a typical mortgage rate was 18%. The cost of carrying a mortgage was extremely expensive, almost prohibitive. Thus the debt to income ratio was under 80%, quite low. But today, the cost of servicing a mortgage is only around 3%, so more Canadians can easily afford to take on larger mortgages. This increases our overall debt levels which skews the debt to income ratio. Of course consumers tend to increase their borrowing if the cost credit becomes cheaper. But that doesn’t necessarily mean they’re at more risk of insolvency.
This is why the debt to income ratio isn’t a very reliable metric to use over long periods of time. It’s impractical to compare debt/income to begin with. The added effects of changing interest rates only makes the wonky ratio even less valid.
Alternatives to the Debt to Income Ratio
I believe a much better metric to measure consumers’ financial situation is the debt to net worth ratio. Debt to net worth (or equity) ratio is what businesses use to determine if they are borrowing too much. They use this ratio to determine debt related goals for themselves. Total-debt-service (TDS) ratio is another helpful way to gauge our debt default risk because it measures how much we pay each month towards debt against how much money we make over the same period. Actually, the Americans often use the TDS ratio, but they refer to it as their “debt to income ratio.” If you’re confused this comment should help clear things up.