Dec 172014

Flawed and Unreliable

The debt to disposable income (DTI) ratio represents the ratio of one’s total debt amount to his after tax income. But the debt to income flaw is not often discussed.

Debt” is a balance sheet item (net worth,) but “income” deals with budgeting (income statement.) Debt is simply a static number, while 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 variables that make up the ratio are loosely correlated at best, but it’s not a very relevant measurement for any practical purpose. 😐

The other problem with this ratio is it’s heavily influenced by monetary policy. 30 years ago the typical mortgage rate was 18%. The cost of carrying a loan 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 DTI ratio. We consumers will naturally increase our borrowing if the cost of credit is cheaper. But that doesn’t necessarily mean we’re at greater risk of insolvency.

14-12-debt-to-income-not-useful-gun, debt to income ratio canada

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 and income to begin with. The added effects of changing interest rates only makes the wonky ratio even less valid. 🙁

Statistics Canada recently announced that our average household debt to disposable income ratio hit a record high of 162.6% in the third quarter, which has generated a lot of discussion in the media. But giving so much attention to this insignificant ratio is like rearranging the deck chairs on the Titanic. Don’t we have more important data to study?

Alternatives to the Debt to Income Ratio

What can we use instead of the debt to income ratio in Canada? 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.

Continue reading »