Why Ratios Don’t Matter…
CTV recently posted an article about Debt to Income Ratios citing that household debt grew faster than income. In addition, Statistics Canada recently released stats stating that not knowing your debt-to-income ratio could come with consequences – full stats here
These types of articles are typically followed with questions such as, “What is a good percentage of debt to income ratio” or “When does a debt to income ratio indicate a problem?”
Ration Smatio ! (Yup, that’s my professional opiion) 🙂
I’m not an advocate for debt ratios, or percentages! Why? Because they put the control of our decisions on someone else. At the end of the day, the percent of debt you have compared to your income, is dependent on many factors, most importantly your level of income and, maybe as equally important, your lifestyle.
Consider this…. A 30% debt ratio for a family on social assistance will have a significantly higher impact on THAT family than a 30% debt ratio for a family with a six-figure household income. Someone with a 40% home-ownership debt ratio who is motivated by staying home and enjoying their property may be quite comfortable. That same person may struggle trying to maintain that debt ratio if their main goal is to travel and socialize.
My advice… take the ‘standard debt ratios’ with a grain of salt. Look at your own financial situation when deciding what makes sense for you. Just because the system tells you that you can afford it, doesn’t mean you can afford it comfortably. At the end of the day, the decision you make should support your lifestyle.
Lets’s play with a couple of examples:
John & Sue – the active couple
John & Sue met in university. At 28 they married. They have been renting for 4 years and are considering buying a home. They both have decent jobs. Although kids are important to them, they are prepared to put off the decision to have children for a few more years to support their travel passion. They go to their bank to see if they pre-qualify for a mortgage. They do. They are approved for a $300,000 mortgage. Wow! They weren’t really prepared to be approved for that large of a mortgage. They begin the search for homes and find a dream home. It’s a bit larger than they need at the moment but they are planning to start a family in the next few years and they certainly don’t want to have to move 5 years from now. They both work hard, have steady jobs and feel they can afford it. And so they buy based on their loan approval. They put travel off for the next year to accommodate some of the extra expenses that come with buying a new home – some cosmetic work, a higher power bill, stocking up on wood for that cozy wood stove and a few minor repairs that were required. Things are a bit tight the following year but they manage their yearly trip down south. Over time, however, it gets more difficult to take those trips. They are spending more time at home and are really missing their annual trips. If they are going to start a family they need to consider it soon. The cost of housing has cut dramatically into their lifestyle and they feel resentment and guilt. Their dream home isn’t quite fulfilling their dreams.
Joe & Sam – the homebodies
Now lets look at Joe & Sam. Let’s assume they were also married in their late 20’s, have been renting for 4 year, both have decent job, and are contemplating starting a family soon. They too go to the bank and are approved for a $300,000 mortgage. They are not travellers. They prefer to stay close to home, preferring to explore their local attractions. They are much-more family oriented and spend time with their families. They decide to invest in their dream home. They consider the cost with their current budget and are prepared to adjust their lifestyle for the next decade to afford it, with a solid plan to pay down the mortgage early creating the potential to live their retirement dream of travel once they are not so tied to family.
Can you spot the difference?
Do you see the difference between the two scenarios? Both have similar financial foundations however their goals and desires are different. And this fact is as important as the current financial considerations.
A great exercise you can do before making a major purchase decision is to look at your current financial situation, which requires expense tracking to ensure you know where you are currently spending your money, followed by a projected outlook based on the variables. The numbers will then speak for themselves.
A few tips to keep in mind:
- If you are estimating your expenses consider that expenses are always under estimated, add 5-10% to your flexible everyday expenses to account for variances. it is better to over-estimate than under-estimate.
- If you have tracked your expenses, and have some history, look at the trend. If you do not have any tracking history, consider adding 2-5% for inflation. I’ve been tracking for over 7 years and I noticed a distinct trend in my grocery expenses. Every year has resulted in my grocery expenditure increasing by $200 per moth. $200 per month!! No matter what strategies I try, I have not been able to get it down. This is an important consideration in any future financial plan.
- A little research goes a long way … if you have specific goals in mind, such as home ownership, or travel or debt repayment, do some research and try to justify your assumptions as best you can.
In summary, standards or ratios are a good starting point. But adding some common-sense and some projected numbers into the plan can help ensure you make a more well-rounded decision. When in doubt, seek expert advice and get 2-3 opinions to help you make the best decision for you.
aka Dr Debt