High Debt-to-Income Ratio Dangerous Even for the Young
Much has been made of the fact that the family debt-to-income ratio has hit 164.6%. In a funny off-colour joke, Preet Banerjee made the point that this is an average and that young people tend to have a higher debt-to-income ratio than older people. Boomer and Echo made a similar point that young people tend to have large mortgages and that their debt-to-income ratio is misleading. I think there is truth in these arguments, but that young people need to be very careful using these arguments to justify taking on enormous debts.
An important goal is to eliminate debt before retirement. Not everyone will succeed, but we can expect the debt-to-income ratio for retirees to be low. Young people buying a house tend to start with large mortgages and smaller incomes than they will have later in life. It’s normal to expect that debt-to-income ratios will be higher among the young than the old.
So, young people whose ratio is higher than the national average can relax. But don’t relax too much. Today’s low interest rates make it far too easy to build huge debts on a modest income. Boomer and Echo use the following example.
This household has a total debt of $393,900 and a yearly income of $66,000, for a ratio of 597%! I think this is crazy. A household in this position should be worried about possible interest rate increases, job loss, or a drop in their home’s value if they need to move.
It’s true that the national average debt-to-income level isn’t a good yardstick for young people, but being too far above this average figure is dangerous. Instead of trying to have everything at once, try easing slowly into a higher-consumption lifestyle. It’s possible to be happy with a modest home and a used car.
An important goal is to eliminate debt before retirement. Not everyone will succeed, but we can expect the debt-to-income ratio for retirees to be low. Young people buying a house tend to start with large mortgages and smaller incomes than they will have later in life. It’s normal to expect that debt-to-income ratios will be higher among the young than the old.
So, young people whose ratio is higher than the national average can relax. But don’t relax too much. Today’s low interest rates make it far too easy to build huge debts on a modest income. Boomer and Echo use the following example.
“If you’re the median Canadian household who brings home $5,500 a month, you should keep your monthly debt payments under $2,200. This sounds pretty reasonable.”Let’s assume that the debt payments in this example are split 80/20 between a 3% 25-year mortgage ($1760/month) and a line of credit ($440/month). This corresponds to a $371,900 mortgage, and if the LOC payments are 2% of the balance per month, the LOC balance is $22,000.
This household has a total debt of $393,900 and a yearly income of $66,000, for a ratio of 597%! I think this is crazy. A household in this position should be worried about possible interest rate increases, job loss, or a drop in their home’s value if they need to move.
It’s true that the national average debt-to-income level isn’t a good yardstick for young people, but being too far above this average figure is dangerous. Instead of trying to have everything at once, try easing slowly into a higher-consumption lifestyle. It’s possible to be happy with a modest home and a used car.
Used car? Ah man, you are a buzz kill, why can't we just lease a car and then flip the lease every year so we have a nice new fresh one? Don't discount the importance of my self-esteem and the car I drive {sarcasm alert}
ReplyDeleteHaving a 371,900 mortgage on a 66K income is plain reckless, unless they have substantial inherited funds to cover for an unexpected. "Crazy" is that should this household go under, the rest of the society will pay the cost of their behavior through the bankruptcy laws which redistribute corporate losses to all consumers. If Lunatic is eager to pay 6-8K for smelling a new car every year, I should not have to pay for it.
ReplyDeleteI think we can all agree that carrying too much debt is a bad thing. And even if you don't carry a lot of debt, many of us would still be in a lot of trouble if we lost our jobs or if our homes plunged in value and we needed to sell.
ReplyDeleteI still maintain that comparing one year's income with debt that's designed to be paid off over 25 years is hard for people to grasp.
TransUnion and Equifax publish reports on non-mortgage debt, and I believe the last quarter report stated that the average Canadian who carries debt owed about $26,000. Car loans made up about half that debt.
@Big Cajun Man: Sometimes sarcasm is an effective way to get a point across. I've known a few people who destroy their finances by flipping cars.
ReplyDelete@AnatoliN: I think that the costs of bankruptcy that can't be extracted from the person who went bankrupt should be borne by lenders to the extent possible.
@Robb: Perhaps this ratio just isn't explained well. If your debt to income ratio is 597%, this means that if you aren't charged any interest, and you don't have to pay any taxes, and all of your income goes to pay off your debt, then your debt will take almost 6 years to pay off. That should scare people.
Why would anyone have an LOC debt of $440 per month? And who would sell a house for $372,000 to someone who only made $66,000 a year? Crazy.
ReplyDeleteI was a little surprised when I calculated our Debt/Income ratio. We're in the "Young" category and have only had our mortgage for 4 years now, but we came in at 168.1%, just a little over the average.
ReplyDelete@B: I suspect you're below average for your age. 168% sounds reasonable enough as long as you're getting it down over time.
DeleteSomething that the Debt to Income ratio misses is how the Income is allocated. For example, each year we grow our savings by a value that represents ~10% of our debt. If we were instead allocating that income to repay debt, the ratio would drop quickly. Since we opt to save it, that savings disappears from the equation.
DeleteThat should be "~10% of our current debt".
Delete@B: You're right that a debt to income ratio does not capture everything you need to know about your finances. Your assets matter as well.
Delete@Tara: It sounds like you're not a fan of debt. Neither am I. But there are many poeple who pay even more than $440/month on their lines of credit. Banks seem quite happy to grant huge mortgages to people as long as the payments fit within a threshold percentage of their gross pay.
ReplyDeleteComparing debt to some measure of income is fairly common. In mortgage lending it's the debt servicing costs that dominates, but outside of that many corporate lines are linked to debt-to-EBITDA metrics. Plus rules-of-thumb like "don't buy a house more than 4 times your income" are income-based since it's hard to do debt servicing ratios in your head.
ReplyDeleteTo get back to the risk element, at the end of the first 5-year term that mortgage would be paid down to $318k. If rates were then 5%, the monthly payment would go up to $2100, not including the line of credit.
And as for Tara's question of who would sell a house over $400k ($372k was just the mortgage) to someone who only makes $66k/yr: Toronto's average residential price is $480k. The median family income in Toronto is just over $68k; for what Stats Canada calls "couple families" it's closer to $80k. Either way, just as bad if not worse than Michael's example.
That's exactly what I thought while reading the original article. There are many examples in accounting I can think back to where debt and current income are linked. As you point out, when rates go up significantly -- which they will -- gross debt won't be the only scary number; "Interest Coverage" is gonna be famous.
Delete@Potato and @Joe: I agree that the possibility of rising interest rates is scary. Those who insist on focusing only on payments/income and never debt/income tend to be overly optimistic.
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