One of the most important factors in determining whether or not a consumer qualifies for a particular loan is the individual’s debt ratio. The debt ratio is essentially a way to determine how much of an individual’s monthly income is spoken for every month in the form of payments that are due. A debt ratio of 60%, for instance, means that 60% of your income every month is required to make your minimum payments on all of your outstanding liabilities.
For example, let’s look at an individual that makes $5000 per month. This person has an auto loan that requires a $450/month payment, student loans that require $120 to be paid monthly, and credit card debt with a required minimum payment of $200 each month. This individual’s debt ratio can be determined by adding the monthly payment amounts and dividing them into the $5000 per month income. In this case, a minimum of $770 is due each month, so the debt ratio is 15.4% (found by dividing $770 into $5000).
For a corporation, the debt ratio is defined as the amount of debt a company has on the books relative to its assets. If a company accepted a loan from a bank of $1 million and the company has $2 million in assets on their balance sheet, the company’s debt ratio is 50% ($1 million divided into $2 million). A debt ratio of great than 1 (or 100%) would indicate that a company has borrowed more money than they have assets to show for it. For a company, the debt ratio will show investors and creditors just how much the company relies on debt to finance its assets.
Why are these numbers important? Because whether you’re an individual looking for a mortgage loan, or a corporation looking for additional financing to grow your business, will find ourselves in situations where we’d like to receive a loan from time to time. When a lender is evaluating us as borrowers, they’re going to take a close look at our other obligations to ensure that they can feel confident that we’ll make our payments.
A lender who makes home loans for example, may establish a rule that they will not issue a mortgage loan that would cause an individual’s debt ratio to exceed 38%. When the lender is deciding how large a loan an applicant qualifies for, they examine all outstanding debt and determine the maximum monthly payment that individual can handle without exceeding their 38% maximum debt ratio. Thus, individuals with a lot of debt and a high debt ratio may have a hard time qualifying for the loan they want, regardless of their credit score and other factors.
Your debt ratio is an important measure regardless of your income. Lenders will only lend to those with a balance sheet that inspires confidence in the borrower’s ability to make their payments. Keeping your debt ratio low will increase your chances of getting the loan you want when you need it.