Economists talk about the debt to income ratio as an important measure of overhanging risk in an economy. In Canada personal debt is about 167% of income. Is that too much, too little or about right? The answer of course, is “Yes!” We’re all different.
One side says that is historically high and therefore bad.
A second argument says that it is not a problem because income is a flow question while debt is static. They are not really the same thing, so the comparison is misleading. The argument is the proper comparison is static debt to static assets. In Canada, debt is about 17% of assets and that seems pretty good.
The debt to asset argument fails on examination too.
Assets and liabilities are balance sheet items. We know them only at a point in time. Like a snap shot. Assets require valuation, while liabilities are contractual. What if asset value depends on the level of liabilities? Static says nothing about a year from now.
Income is a dynamic. The number does not mean much by itself, but has meaning over a period of time instead of at a point in time. All analysis should look for a way to connect income flow with static liability. The initial ratio of debt to income is easy but meaningless.
In the case of debt to income the connector is debt service cost. If I owe 167% of income and pay only interest at 3%, I pay around 5% of income. The debt is innocuous and my debt service capability is quite strong. If though, I pay 5% interest and am required to pay the debt off over 20 years, then the debt service of principal and interest is 13% of income. To pay in 10 years is 21%. Now I am not so safe. Even less so if interest is 8%
Worse still, in Canada a good deal of the asset total is personal real estate and most of the debt is a mortgage on it. While that asset value looks like a static thing, it is not. The value of the house will vary with the cost of financing. A house that is affordable when rates are 3% is much less affordable when they are 6%. At renewal higher share of income. On a sale, the purchaser will demand a price reduction so their resulting mortgage payments are affordable. So the asset value is part of the flow problem of income and debt service.
In both analyses, another important factor is that the asset stack we have been discussing seldom displays the biggest asset. The ability to earn income. For a young person the ability to earn income is a far more valuable asset than is the house where they live. The present value of future income depends on tax rates, investment rates, inflation and the duration of earning. Just arithmetic to calculate. Today, for someone five years established in their career, the after tax value of future earnings is between 15 and 20 times their present annual income.
Houses are a small fraction of that. Probably no more than 4 times earnings.
Moral of the story.
- Don’t get caught up in average ratios. They mean nothing on an individual basis. Work out your own situation. Find what is affordable and build in a cushion for change.
- Your house and your used furniture are fully insured. I will bet your income value is not. Do something about that. Without your income, the ratios can become very adverse.
Too detailed and analytical to worry about?
Rational helps you understand meaning and meaning matters. It’s hard to be rational, but you don’t have to do it very often.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772