How to calculate your debt ratio?
May 27, 2019
Calculation of the debt ratio
Subscribing a credit is not a step to take lightly. This is often a necessary operation but can be risky for both the borrower and the lender. That is why it is important to ensure in advance of its ability to repay by the operation of the calculation of the debt ratio.
What is the calculation of the debt ratio?
This is the operation to know what is in the budget the amount of repayments of loans of any type of borrower. Roughly, the calculation of the debt ratio is the proportion of loan monthly payments on monthly net income.
Nevertheless, each credit institution has its own criteria for calculating the debt ratio. Some take into account all the recurring expenses of the household (for example tax charges, rents, etc.). In reality, it is a confusion that is often made between the debt ratio and the rest of life; we will return to the distinction between these two notions below.
How to calculate the debt ratio?
Most financial organizations, or comparators of credit offers, make available their own tool for calculating the debt ratio. It is then sufficient to fill in the requested information.
However, it is possible to make oneself, beforehand, his own calculation of the debt ratio. This is even strongly recommended to prepare your project as well as possible and to make you aware of the importance of the situation. Indeed, as you will see earlier, the debt ratio is generally the basis of the demand for a loan. In all cases, when preparing your loan application file, the lender will calculate the debt ratio.
his calculation of the debt ratio is done in several stages:
- First of all, you have to calculate the monthly income. In case of fixed income, the operation is relatively simple. If your income varies each month, take an average of the last 15 months – however, the income on a tax notice is more taken into account by the credit agencies than the pay slips.
- Then group all outstanding loans and calculate the amount of monthly payments. It is important not to fool the lender at this stage. In fact, not only would the latter refuse to grant you the credit but you would also be on a “black list” preventing you from obtaining a new loan, or he could cancel a credit already granted. Once all the monthly payments have been obtained, add up all the installments using the depreciation tables. These can be obtained free of charge from your lender.
- Finally, you can proceed to calculate the debt ratio by the operation: Total monthly payments / Total monthly income . Generally, the result is expressed as a percentage (we obtain a number with two decimal places multiplied by 100).
For example: A household has monthly payments of 600 € and monthly income of 2800 €. Its debt ratio is: 600/2800 = 0.21 or 21%.
Note: The calculation of the debt ratio on rental investment.
If you have a home loan for a property that you intend to rent, or if you are applying for such a property, you are certainly concerned with the rental investment. In this case, the methods for calculating the debt ratio are not the same.
Indeed, the bank will only take into account the net rental income to take into account the property charges – that is 70% of the rent that you will collect. It is true that the operation can be complex at the stage of the application since it is already necessary to take into account the average current rent. Moreover, to calculate the future debt ratio, the organizations differ according to whether or not they apply income compensation.
To be clearer, let’s take a simple example. A household has 4000 € of monthly income and monthly installments of credit of 800 €. They intend to subscribe to a mortgage whose monthly payments will be 500 € and which will bring them 300 € rent per month.
If the lender practices income compensation, the calculation of the debt ratio will be done according to this operation: / Taxable income
Either: / 4000 = 0.25 or 25% of debt ratio
If the lender practices the non-compensation of the income, the calculation of the debt ratio will be done according to this operation: (Current monthly payments + monthly payments of the rental financing) / (Net rental income + Taxable income)
Either: (800 + 500) / (300 + 4000) = 0.30 or 30% of debt ratio
What is the point of calculating the debt ratio?
The primary interest in calculating the debt ratio is whether lenders will give you credit. The latter will not commit if the applicant’s future debt ratio, taking into account the new loan, exceeds 33% since this index makes it possible to ensure the financial solvency of the borrower.
Also, it conditions the credit rate: the more the calculation of the debt ratio reveals a low result, the higher the credit rate will be and the monthly payments will be lightened. Indeed, your file will appear as sufficiently secure for the creditors to guarantee the financial operation.
However, the calculation of the debt ratio may prove useful beyond the mere assumption of the loan application. Indeed, it makes it possible to check one’s personal situation with regard to the risk of indebtedness. Therefore, it is useful to make important decisions: revision of the expenses, better management of the budget, even to initiate a procedure of over-indebtedness in the most serious cases.
What is the difference between the calculation of the debt ratio and that of the “rest to live”?
The remainder to live is an important concept and to define when one is interested in the calculation of the rate of indebtedness. It corresponds to what the home has to live when it has paid its fixed and incompressible monthly charges.
His calculation is relatively simple. It corresponds to the household income from which fixed expenses are deducted. Income refers to wages (or equivalent: unemployment benefits, pensions, …), allowances, etc. The regular monthly charges include rent, housing expenses (energy, insurance, …), taxes, credit repayments, pensions paid and transportation costs.
Financial institutions, when studying the loan application, do not simply take into account the monthly payments of loans in progress. Indeed, it is the rest to live that will measure the financial capacity of the borrower, that is to say the money that will be intended to repay the credit and therefore the amount of additional debt. This is why the calculation of the debt ratio is essential but not sufficient – also, the calculation of the debt ratio can be satisfactory while the rest to live is not high enough to contract a new credit without being threatened with over-indebtedness as shown in the following example:
A household consists of two people earning € 1200 and € 1400 per month respectively. They subscribed to a car loan with a monthly payment of € 370. Their rent and expenses come back to 950 €, their transport costs to 140 € and their taxes to 300 €. They want to apply for a home loan to finance the purchase of a second home.
Realize the calculation of the debt ratio: Total monthly payments / Total monthly income = 370 / (1200 + 1400) = 14%. A priori, their request should be accepted because this rate is lower than 33%.
Now, let’s calculate their rest to live: Revenues – Fixed charges = (1200 + 1400) – (370 + 950 + 140 + 300) = 2600 – 1760 = 840 €. To obtain their rate of rest to live, it is enough to calculate: Stay to live / Income of the hearth = 32%.
Admittedly, there is no reference rate of rest to live since everyone does not have the same income. However, it must be kept in mind that the smaller the source of income, the higher the rate of rest to live. But here, the rate of remains to be obtained is relatively low which indicates a risk of over-indebtedness that can scare financial organizations. But this would not have appeared with the simple calculation of the debt ratio. We can see that the calculation of the debt ratio alone is not relevant in the loan application. However, it remains essential.
What if the calculation of the debt ratio is not favorable to me?
As we saw earlier, financial organizations refuse credit applications when the calculation of the debt ratio results in a result above 33%. One of the solutions is the grouping of credits: an organization will group together all the loans to form a global one. There will be only one monthly payment per month that will be recalculated according to the household’s current repayment capacity.
This solution makes it possible to manage the credits as well as possible and generally to review the repayments downwards. Thus, the recalculation of the debt ratio should lead to a lower result. However, pooling credit is not a quick fix; this is why the calculation of the debt ratio must be done first and foremost as part of the management of its budget and not only when the question of a loan application is raised.