What is a healthy debt ratio and how do you achieve one?
We all work hard for our money so that we can afford the life we want to lead. But in the midst of dealing with the demands of everyday life, we can forget to check our financial health.
As revealing as it is, not everyone has the time or inclination to sit down with a professional to openly discuss how things are and where they are likely to go if not verified.
A quick and easy way to get an overview of your financial health is to check your debt ratio.
What is the Debt Asset Ratio?
The Debt Asset Ratio is a commonly used financial indicator that is used to describe a company’s financial status. This can be in the form of a number or a percentage.
In relation to a company, the debt asset ratio and the debt equity ratio describe the debt of the company compared to the asset or the value of the shares (equity).
To individuals, the Debt Asset Ratio or Debt Income Ratio have essentially the same meaning and can be used interchangeably.
Put simply, the debt asset ratio is a measure of the amount of debt to wealth or income. Depending on how high the number is, there are important implications.
ALSO READ: 2 Strategies To Consider When Paying Off Debt In Singapore
How to Calculate Your Debt Asset Ratio
Step 1: Calculate How Much Debt You Are Paying Back Each Month
This is the total of your unsecured debts such as credit cards, personal loans and lines of credit, and outstanding loans such as student loans. If you have a mortgage that you pay in cash (rather than CPF) add that too.
Step 2: Divide the total monthly debt by your monthly income
This is your take-away payment according to CPF plus regular income, such as from side appearances or investment dividends.
Step 3: multiply that number by 100
This derives a percentage for your debt ratio.
Here is an example of how you can find your debt ratio:
|Total monthly debt||Total monthly income||Debt asset ratio in percent|
|$ 1,200||$ 4,000||30th|
Calculation: 1200/4000 x 100 = 30
ALSO READ: Why It Is So Important To Pay Off Your Credit Card Debt During Covid-19
Why don’t we use gross salary?
When calculating your debt ratio, we use your net income (after CPF deductions) instead of your gross salary. This is because your CPF savings cannot be used to pay back your debt. Therefore, they should not count towards your total income or net worth.
For the same reason, if you have a mortgage that is paid through your CPF, you should exclude that amount from your total monthly debt to avoid skewing the ratio.
However, if your mortgage is paid in cash rather than CPF, you will need to add this to your total monthly debt for an accurate picture.
Why Do You Need To Know Your Debt Ratio?
Your debt ratio tells you a few important things, such as:
- The likelihood of getting a loan
- The status of your cash flow
- The likelihood that you can retire in comfort
1. The higher your debt ratio, the lower your chances of getting a loan
When you have a high debt ratio, it means that a large part of your income will be used to pay off debts.
That leaves less to cover your other expenses.
Banks and other lenders see this as the risk of defaulting on your debt. Above a certain threshold, they can simply reject your loan application as they consider the likelihood that you will meet your debt obligations to be low.
Therefore, if you have tried to get this home renovation loan, try to pay off some of your debts first. This will lower your debt ratio and increase your chances of your loan application being approved.
2. The more you pay in debt, the weaker your cash flow will be
In our example above, we have a debt ratio of 30 percent ($ 1,200) with net income of $ 4,000, leaving only $ 2,800 to cover our other expenses. You can imagine that this doesn’t leave much for other expenses outside of our daily necessities like groceries, groceries, utilities, and insurance.
Forget about starting or building your emergency fund. That’ll have to wait until another day along with important things like investing in the future.
What if you encounter an emergency that costs a few thousand dollars? You’ll need to dip into (potentially wipe them out) your savings or take out a personal loan or, as a last resort, cover the costs with a credit card.
Now imagine if your debt ratio were cut in half to 15 percent, giving you an additional $ 600 a month. Your cash flow would be much stronger and you could at least tackle some of these crucial financial goals.
3. The longer your debt ratio stays high, the less likely it is that you will be able to retire in comfort (unless you are already rich).
For an average salary individual, economic life is limited to the number of years in which you can reliably earn an income. The more of those years you spend with a high debt ratio, the fewer assets you can keep for your own purposes, such as retirement.
Therefore, if your debt ratio has been high for an extended period of time and is likely to remain high, you risk your ability to retire comfortably (or at all).
Our article, created in partnership with CPF, will tell you exactly how much you need to comfortably retire based on your lifestyle choices.
What is a healthy debt ratio?
Ideally, your debt ratio should be 0 percent. However, this would also leave no room for necessary and useful credit, which is inconvenient for those of us who do not own a diamond mine. Hence, the real world requires a more nuanced approach.
It is important to realize that not all debt is bad or undesirable. Instead, we need to weigh debt against potential improvements in our quality of life.
For example, instead of staying in the cramped childhood home, buying your own property gives you a more suitable environment to start your own family. Plus, once you’ve paid off the mortgage, your home becomes an asset.
Similarly, attending the long-awaited Masters can help you reach greater heights in your career, and buying a car can help you make extra cash on the weekends as a private driver.
All of these scenarios would likely involve taking out a loan or mortgage and increasing your debt ratio. In return, however, you benefit from numerous advantages.
Therefore, a healthy debt ratio is ideally as low as possible, but as long as you are able to manage your finances with ease, don’t be afraid of taking on a little debt.
Tips to Lower Your Debt Ratio
When you feel the pressure of a high debt ratio, the solution is straightforward: eliminate as much of your debt as possible, avoid borrowing more, and increase your income.
Here are some tips to help you lower your debt ratio.
1. Consolidate your debt
Use a 0 percent transfer to pay off your outstanding credit card balances, then focus on paying back your transfer within the interest-free period. This will help you shorten the length of time you are in debt.
If you can’t find a suitable balance transfer, try consolidating your debts with a personal loan instead. Apply for the shortest tenure you can comfortably get out of debt as quickly as possible.
2. Accelerate your debt settlement
If you have cash left over at the end of the month, it may be worth using it to help pay off your debt faster. Yes, it will increase your debt ratio, but it will speed up your repayment period. And over time, even $ 50 more per month can put a significant strain on your mountain of debt.
3. Withdraw whatever you can now
Look for credit cards with low balances or loans with few installments. If you have cash, pay it out in a lump sum to reduce some of your debt ratio. Be aware, however, that you may be charged an early loan repayment fee.
4. Increase your income
Scrimping and saving can only get you so far. Consider making a side step for higher income that you can invest in paying off debt so that you can save yourself further trouble going forward.
This article was first published on SingSaver.com.sg.