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.
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.
Unfortunately a faulty measuring tool can only produce unreliable results, which of course leads to unsubstantiated reactions by politicians. 😕 Based on this phony 162.6% figure the federal government is warning that Canadians have become too indebted. Many economists, not surprisingly, like to point out the obvious and remind consumers that household debt can be a risk to their financial stability (gee, you don’t say. 🙄 ) Even Mr. Poloz from the Bank of Canada flagged household debt as “a significant risk to Canada’s economy.”
But hold on a minute. 163% DTI ratio is considered too high? If someone earns $50,000 a year, and lives in a $1,190,000 Vancouver shed which still has a $190,000 mortgage on it, then his debt to income ratio would be 380% ($190K/$50K). Oh no! 🙁 That’s more than twice the national average DTI ratio of 163%. This person surely has too much debt and is in dire financial trouble. The poor guy must be super stressed over his crushing mortgage payment of $900/month. 🙄 What if he loses his job and can’t find a renter to provide him with a stable income? I guess he’ll have to sell his primary residence and find some way to get by on only $1,000,000. 😛
Yup, that’s a real listing I found today. But all jokes aside this demonstrates yet another flaw with the foolish debt to income ratio. It looks at debt but ignores the asset column. And it uses income without looking at expenses. Like seriously 😕 I wish people would stop giving so much credit to this faulty indicator.
Doesn’t Matter, Had Gains
According to the CBC, our combined personal debt has increased by 1.5% last quarter, but over the same time our wealth has also grown by 1.3%. Financial experts warn that this trend isn’t good because our debt is growing at a faster rate than our net worth. The sum total of our total debt is some total eh. Haha 😀 But again, don’t get fooled by mainstream thinking. The truth is that Canadians only have about $1.8 trillion of debt, but we have $8.1 trillion of combined net worth! So if our debt increases by $27 billion, but we’re all $105 billion richer collectively then isn’t that a good thing? I certainly think so, because we can technically pay off our newly acquired debt immediately and still be ahead of where we were. 😀
We are clearly in control of our finances. We have the means to pay down our debt at any time should interest rates go up. But for now our money can be better used elsewhere to create wealth. And Canadians know this. Borrowing money to buy a house, a practical education, or a diversified stock portfolio have all proved to be worthwhile financial decisions in the past several years. Canadians are “horny for debt,” as Garth would say. 😉 And why shouldn’t we be? Housing is in short supply. Vacancy rates in large cities are tight. With millions of new immigrants expected to move here over the next decade, the demand for our land and resources should only increase in the long run. Since there are no visible signals of an upcoming economic shock, Canadians continue to prioritize growth over deleverage.
As long as the BoC’s overnight rate remains at 1.00% I don’t expect Canadians will over extend on debt until our average DTI ratio reaches 200% or higher. So we still have a decent margin of safety. 🙂
Cutting Out the Noise
I believe Canadians are not overly indebted. We still have the capacity to borrow a lot more money if we wish to. The delinquency rate (bills past 90 days due) remains on a downward trend and now stands at just 1.11% of all loans in Canada, the lowest level since 2008, according to credit bureau Equifax. If our debt has become such a big burden like the popular narrative states, then why have consumer bankruptcies declined 5% over the last year? The truth is less people have late payments today than any previous year in recent memory.
Interest rates will inevitably rise some day, but it will be a drawn out and calculated process which means we’ll have plenty of time to readjust our financial habits.
The debt to income ratio is flawed. We should ignore the tosh out there that Canadians have a debt problem and it’s going to blow up in our faces. We have to think for ourselves. The real test of our financial resilience is very individualized. To some it may be rising interest rates. To others it might be long term unemployment. Whatever the case may be we have to prepare for it. I recommend creating a stress test chart because it’s fast, easy, and effective. Once you know the limits of your own debt situation and understand how to protect yourself against any possible risk then you won’t need some arbitrary Candian debt to income ratio to determine your financial future. 🙂
[Edit as per commentator’s suggestion]
I do not encourage people to go into debt. I am not qualified to give any financial advice. Please see my Legal page for full disclaimer. This article is only meant to point out that the debt-to-income ratio, in my own personal opinion, is not the best measurement to gauge someone’s ability to pay back debt. When interest rates move higher the cost to service debt will increase and people who have borrowed money will be at greater risk of not being able to pay it back. Please borrow responsibly and don’t over extend yourself. Know your limit, borrow within it. 😀
Random Useless Fact:
One mouse click burns 0.0014 Calories. So to burn off a Big Mac you’ll have to press your mouse 350,000 times.
Very appropriate rant… an understanding of the statistics clearly shows how they can be manipulated and misinterpreted. – Cheers
Completely agreed. 🙂 With so much information out there we have to look past the narrative and focus on the indicators that really matter to our bottom line.
Very good points in the article, I can see how the stat can be manipulated and misinterpreted for sure. Debt to net worth ratio would be an interesting number to see.
Absolutely. Unfortunately I have a feeling many people don’t know how to calculate their net worths 🙁
You had me at “scalar against a vector” lol
The person who you mentioned in one of your previous posts that bookmarked your website with ‘over leveraged guy, check back later’ needs to read this post lol
So cool that you referenced our constructive comments on your stress tests page BTW! Goes to show how the FI crowd quickly and efficiently work though finance vernacular through the use of reference links HA.
And totally agree…
TDS and D/NW >>>> DTI
Haha, I also wonder if he’ll come back and read this post. There are clearly other people borrowing to invest in both Canada and the U.S. and for the most part they have done well for themselves. 🙂
I’m actually working on a follow up post to my previous article about my blog being judged. I’m hoping it will be just as fun as the first post 😀
[…] discusses drawbacks of the Debt to Income ratio, equipped with delightful […]
I partly agree
I think it does provide a high level indication of your ability to service the dept.
Bank knows that the current interest rate are abnormaly low.
Take your 50k$/year guy living in the 1 190k$ Van condo with 190k$ mortage. Imagine interest rate raise 1% in 2015 and another 1% in 2017 just when he has to renew (not saying it will happen, but it’s not totaly imposible either). It will make his mortage payment goes from 900$ to 1300$… Now has to sell but the higher interest rate also made the market tank and the value of his condo is now 980k. He’ll have to take a major haircut.
Same guy with a 70k$/year might have the ability of waiting it out and not be forced to sell in a tanking RE market.
Yes, very true. I agree that it will be harder for him to service the debt in the future because he’ll be paying $1300 a month instead of $900. 🙂 I like your example of interest rates rising 2% total by 2017. Like you said, we’re not saying it will happen, but let’s just pretend it will to demonstrate why a higher DTI ratio is not necessarily better than a lower one. In that case by 2017 this person’s debt to income ratio would be lower than it is today because he’ll have paid down a portion of his principle mortgage loan. Yet, I would argue he is more at risk of not making his debt obligations on time because his monthly expenses will go up by $400. His debt will become a bigger problem for him in 2017, when his DTI ratio will be lower, than it is today. The authorities in Canada are misleading people to believe that a higher debt to income ratio means more risk, when in reality the opposite is often the case. I hope people will realize that the ratio does provide a high level indication of one’s ability to service debt, but only… Read more »
Never posted here before, but this post begged for rebuttal. I think you’ve missed the point of what the debt-to-income ratio is about. It still has a lot of use for measuring of stress, in the sense that the debt will become more difficult to manage as rates normalize; something, incidentally, that should be pointed out. 18% is ridiculously high, the same way that 3% is ridiculously low. Can people manage their debt at 7%? Studies show that no, we cannot. … And saying that Canadians know they can pay their debt off immediately but choose not to because of the low rates? There are many, many other studies that show this isn’t the case. There are well publicized reports about Canadians’ inability to save or pay down debt in a meaningful way. Here’s just one. business.financialpost.com/2014/09/10/more-canadian-workers-are-living-paycheque-to-paycheque-saving-less-survey/ So, I would agree, the measurement on it’s own is not fully indicative, but comparatively it is still useful. Like, in how we have surpassed the levels reached by the Americans in debt/income ratio. Combined with the details in reports like those provided in the link above, plus the fact that boomers are entering retirement with more debt and mortgages than ever in… Read more »
Nice rebuttal, Grooby. 🙂 I guess it was presumptuous of me to think most Canadians can pay off their debts quickly. I was only thinking about my own situation and that of all my friends. If mortgage rates went up to a normalized level, such as the 7% you mentioned, then I know I would pay off my mortgage and be debt free within days. I might have to sell some stocks in order to do this, but it will be the right decision because I don’t believe I can make more than 7% return on my investments. I think I wrongly assumed many others can do the same as well because from one of my earlier blog polls it appears that all of my readers have a positive net worth, like myself, which means they can become debt free too, if they wish to be. Some people may have to sell their homes and rent, but if they truly want to be debt free then maybe it’s worth it. Besides, I agree with you that selling a Canadian home today may turn out to be a great financial decision. Get out before the crash right? 😀 I know some… Read more »
Median net worth for households in Canada is $243,800 according to Stats Can . For households headed by under 35s it is $25,300.
Average is closer to your figure, but averages are useless due to extreme outliers.
Doh. You’re right. My bad. I was thinking of the average. The range between provinces is amazing. The median household net worth in BC is $344,000 but in PEI it’s less than half that amount.
You also have the highest household debt over there (both in terms of mortgage and non-mortgage debt).
Here’s an old post where I go on about debt-to-income being a population measure so changes in the ratio matter more than the absolute level.
The big issue with debt-to-net-worth is that net worth can be inflated in an asset bubble, and all the way up it looks totally healthy. If/when the bubble bursts, the debt remains as the asset prices fall, and only then does the measure look bad.
Thanks for sharing your article, Potato. That is some pretty great insight. I think you’re right. The ratio is pretty much a population measure and will be affected by changing demographics. I’m glad other bloggers like Robb share my sentiments about the debt to income ratio as having a “splashy headline” and is over hyped by mainstream news. 🙂
Good point about the debt to net worth ratio. I guess every metric of financial measurement has its flaws and weaknesses! 😉
Ask the Americans who were underwater on their mortgages and forced to sell their homes at a loss how they feel about the Debt to income ratio. The ratio serves a purpose: it illustrates in a comparative way people’s ability to service their debt. It is independent of interest rates because that is part of the point: those with a high debt to income ratio, and a rate change (rates were at 6 or 7 percent not too long ago!) will not be able to service debt anymore. Because of their income in relation to their debt. That’s very relevant these days, when so many of us are heavily indebted. Your example of the vancouverite in a million dollar + house would be totally screwed in the case of rising interest rates and a falling house market. Just to put yourself in their shoes… This could happen in Canada as well: money.cnn.com/2008/10/30/real_estate/underwater_borrowers/ I owned a house (in Canada) at that time, purchased in 2006 with a mortgage of 500k. I had a similar attitude to debt as you back then (even though rates were higher) and didn’t think it was a big deal… Until 2008 when the market crashed and… Read more »
Hey Stephanie! Long time. 😀 Wow, that is crazy. 7.5 million home owners were underwater. I’m not over 35 or live in the U.S. so I think that’s why I’m not aware of the risk of being overly indebted. But that’s no excuse for me to be naive either. I wonder if there’s a way to determine what the optimal debt-to-income ratio would be. Perhaps there’s a range like between 100% to 120% maybe? And if someone has a higher ratio then that it means they are more at risk of defaulting than others. I feel like if there was some kind of guideline that everyone can agree on it would make things easier. 🙂 It’s interesting once you dive into the details of this ratio because if it’s meant to illustrate “in a comparative way people’s ability to service their debt,” then should the “type” of debt be taken into consideration? For example, 2 individuals are making $50,000 per year each. One has a 5 year car loan with a balance at $50,000 at 4% interest rate. The other has a $100,000 mortgage with a 3% interest rate, amortized over 25 years. Car owner: debt-to-income ratio = 100% Home… Read more »
The vast majority of debt owing by Canadians is for mortgage debt, not car loan debt. My point is that houses are not liquid assets, if interest rates rise, which is a widespread national event, and those with low income have no choice but to sell their house, on a massive scale, then the housing market will collapse. This is why this ratio is useful. It’s not perfect, but as I said, it is an illustration of our situation. To say there’s no danger here makes you seem either naive or looking out for more clicks… No offence.
Happy holidays to you too!
Ps sometimes I wonder if you post this sort of nonsense for a boost in traffic… But seriously, you have to be a little more responsible as a “financial blogger.” There are, I’m sure, a few twenty somethings who read this and believe everything they read on the Internet when it’s written in an authoritative tone on something that looks like a financial blog. You are not qualified to encourage people further into indebtedness. If you do post things like this, you have to acknowledge the risks involved in over indebtedness as well. People with low incomes and high debts who are already feeling stretched will NOT be able to “readjust their financial habits” in the case of a normal rise in interest rates. That is total bullshit and probably offensive to the hardworking people who were forced into bankruptcy or foreclosure after having the same cavalier attitude towards debt as you do.
Oh nice call. That was an oversight on my part. I have just updated the post near the bottom to acknowledge the risks of having too much debt and to warn people against biting off more than they can chew. Good thing I have readers keeping me accountable. Sorry if I offended any hard working people who went through bankruptcy. 🙁 Hopefully I’ll remember cover all my bases next time.
Aww, Really? You think my blog has an authoritative tone? 🙂 You’re too kind. 😀
I don’t see people using total amount of debt vs income as a ratio. debt payment vs income yes and also total debt vs total assets but not the former.
I couldn’t have said it better myself. 😀 I never see people using total amount of debt vs income, except in Canada. No economist or business reporter that I know of in the United States, the world’s largest economy, measures the risk of someone’s indebtedness in this way. I think that alone speaks volumes about the validity of this ratio. Debt payment vs income ratio is the most often used metric in the U.S. and other countries around the world, and I have gone on record before as saying I’m very much in favour of that method. Yet here in Canada, the only time this ratio comes up is when someone is applying for a mortgage. I like the total debt to total assets ratio as well. In both of these measurements we’re comparing like values. Debt servicing and income deals with cash flow. Total debts and assets measure overall financial wealth (net worth) before taxes. They both make more sense than Canada’s DTI ratio to be perfectly honest. Our version of the debt payment vs income method is called the TDS ratio. It’s much better than the DTI ratio because it tells us measurable indicators and actually puts real… Read more »
You are kidding, right? The delinquency rate is low because interest rates are low. The minute this changes, then talk about delinquency. This is along the lines of ‘it hasn’t happened so it isn’t going to happen’ argument. Do you really believe that the vast majority of borrowers in the last 10 years have been responsible and are not leveraging themselves to buy million dollar homes? Just look at the median incomes across the country and you can see how dangerous this debt binge is.
I am also a first time poster, and have enjoyed some of your previous posts, but this one is seriously disappointing.
And what good is a ‘debt to net worth ratio’ when such a large proportion of the current net worth of many home owners in Canada is a direct result of the leverage caused by the debt bubble? Once one pops, so does the other. Useless metric.
Liquid net worth to debt would be slightly more useful.
Do I look like the type of person who kids? 👿 Lol, just kidding. 😎 I simply pointed out that it’s been getting easier for Canadians to service their debts because late payments and bankruptcies are going down. I did not make any predictions about these numbers going forward though. But in all seriousness I would be just as interested as you are to see how the delinquency rates change as interest rates increase in the future. 🙂 And to answer your question about my opinion on Canadian borrowers, yes I do believe the vast majority of us have borrowed responsibly in the last decade. 😀 But hey, I’m not an economist or financial advisor so what do I know? I think that large amounts of debt isn’t necessarily a bad thing. But a poorly managed increase to the cost of borrowing will definitely wreck havoc on people’s finances. If you watch Top Gear you may have come across Jeremy Clarkson saying that speeding and driving really fast isn’t dangerous. It’s coming to a sudden stop that kills you. I interpret the asset bubble in Canada’s financial market the same way. Yes, like yourself, I do believe our assets are… Read more »
I do apologize if I came off sounding harsh, and your poster is correct, you do have a way of being even-keeled in your responses. I get passionate about the debt situation in Canada relating to real estate because I have so many Irish, American, Spanish, and Gulf-expat friends who felt the exact same way about the debt they were using to purchase property. And then it fell apart.
I am yet to find evidence of a successfully ‘engineered’ soft landing by any government. Let’s hope you are right, but the majority of people I know in the 25-35 range have put very little down, leveraged as much as the bank told them they could ‘afford’ and would not be able to withstand any interest rate increase. The problem is that we have convinced ourselves that interest rates will never increase … ever … and that the BOC is in control of this.
The bigger issue is how this will affect the rest of us who have no debt and who did not pay 9x our income to get in the game.
No need to apologize. 🙂 You brought a different angle to the discussion that I did not cover in my original post. So thanks to you all the other visitors who read your comments will probably learn something new and useful. 😀
I plan to dedicate more time next year to talk about debt and Canada’s real estate bubble. One thing I want to cover is moral hazard, or the lack of incentive to guard against risk where one is protected from its consequences, e.g., by insurance. It’s unfortunate that the responsible minority have to deal with the ramifications of the overly leveraged, but maybe there are ways to stay protected.
Thanks Liquid. I think incentives and moral hazards in this area would be a great topic. You might want to start with the relationship between the CMHC and the Big Five banks. So few Canadians I speak to seem to realized that there is basically no incentive to curtail mortgage lending at this point since taxpayers are backstopping these loans.
Liquid; If you don’t mind me saying this, I think you have alot of the qualities of what makes a good corporate executive. You have the ability to respond positively to critism with both analysis, and positivity. When people expose you to the realities of risk in a critical manner; it seems you respond with risk mitigation strategies and good humor.
Keep up the good work. This is why I am a regular reader of your articles.
One thing I just noticed in the recent CDN equity “oil”bath; was that my modest but well diversified financial portfolio held it’s own quite well. My bonds and international equities balanced the scale nicely. I think I see the advantage of your well diversified monumental portfolio.
In your opinion Liquid, long-term, what portion of your portfolio would you like to have in real-estate vs. financial? I have been trying to figure this one out and need some direction. Thx!
Thank you JR! It’s very kind of you to say that. 🙂 I do enjoy having discussions with my readers. To me it doesn’t matter if everyone agrees on the same thing or not. What’s actually important, I think, is that everyone understands. 😀 It’s all about the bigger picture and understanding where we stand in the ever-changing world of financial possibilities. You’ve made a smart move diversifying your portfolio. Canadian equities are down this month, but bonds and U.S. equities are doing okay so far. Great question about asset allocation. There’s a lot of things to consider and to be honest I don’t know either. I think I would be comfortable holding somewhere between 30% to 70% of my investments in real-estate. I know that’s a large range haha. But here are some factors I would consider. Age: Younger = more real-estate in portfolio. Older = less. When we’re younger we have the human capital, or physical/mental capability to haul ass and be more adaptive to changing economic events. If a recession hits we can bootstrap our way out of difficulties. It’s also easier to relocate for younger households, especially singles or couples, if they have to sell their… Read more »
I’m sitting here laughing at all these comments my friend. Great post, interesting comments and some very interesting rebuttals. As the Offspring song is so titled, You’re Gonna Go far Kid! As I’ve pointed out in the past it is interesting to read some of these comments and guess the ages, backgrounds and stages in life their at. Grinning smugly as always… – Holiday Cheers.
Great song! 🙂 Yes, a lot of different opinions on on this topic it seems. Holiday cheers to you as well. 😀
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