Debt to Income Ratio Exposed – A Deceptive Fallacy

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.

Fearmongering

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. 😀

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