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Are you in the debt danger zone?

Are you in the debt danger zone?

 

For every one dollar Canadians earn in one year, we owe $1.63. The latest figure from Statistics Canada is shocking when you consider that not even twenty years ago we owed less than our annual income.

Economists see the debt-to-income ratio of 163 as a warning sign that the national household debt level will be unmanageable when interest rates eventually rise.

Debt-to-income is a metric used for and by banks and governments to determine the risk of default — specifically the ability to service debt on a regular basis. While the various debt-to-income ratios speak volumes about Canada's ability to cope with financial shocks on a macro level it gives very little information to individuals who want to know if they are in the danger zone.

Are you in the danger zone?

Here's an example: a young family with an annual combined household after-tax income of $100,000 and a 5 per cent mortgage of $300,000, owes $3 for every dollar it brings in.

Their neighbours - who are nearing retirement - also earn $100,000 a year, rent their home and carry $50,000 in high-interest debt on their credit cards, lines of credit and other personal loans. They owe fifty cents for every dollar earned.

On the surface the young couple with a debt to income ratio of 300 would seem to be in deep trouble and the older couple with a debt to income ratio of 50 would seem to be on easy street.

The truth is; the debt to income metric does not distinguish between low-interest, equity-building debt (like a mortgage) and high-interest, compounding debt (like credit card debt) because it only focuses on whether the debt will be serviced.

The metric also doesn't take into account the fiscal discipline of an individual household, or how younger borrowers have several years of income to tackle debt while older households face a debt wall at retirement.

Debt serviceability ratios are a game of averages and individuals looking for where they stand are better off reviewing their personal income, expenditures and debt payments to get a more accurate picture of their financial health. Obviously, a lifestyle where monthly debt payments exceed income after living expenses is unsustainable.

Even balancing the books at the end of the month won't cut it if you want to build a sound financial future. You need to pay down debt with a goal toward eliminating it, and save through regular cash contributions. For most it takes time, and the best way to benchmark your progress is through another ratio: debt to assets.

The debt-to-asset benchmark

Individuals wanting to measure their financial health over time should compare their debt to their assets — how much you would you owe or own if all your assets were sold — your net worth.

Debt is measured the same way as the debt to income ratio.

Assets include savings, inside or outside a registered retirement savings plan, or a tax free savings account, cash, and any other property that appreciates or holds its value. It's important to be realistic about the value and potential appreciation of your assets.

Assets also include the current market value of a house. Despite recent warnings of an impending downturn in the housing market the Canada Mortgage and Housing Corporation estimates the average home appreciates in value by more than 5 per cent annually over 30-year periods.

To determine the debt-to-asset ratio simply divide assets into debt and multiply by 100.

A result below 100 may be discouraging but set annual goals for debt reduction, savings, and factor in a modest appreciation for your investments.

With those three factors at work simultaneously you may be surprised how quickly you get to beyond 100, eventually wipe out debt, and have a nest egg to enjoy.

SOURCE:http://ca.finance.yahoo.com/blogs/insight/debt-danger-zone-172346276.html