Debt ratio is one of those terms that get thrown around when looking for loans. What is debt ratio and what does it mean for you and your debt? There are a couple ways to look at debt ratio, but first, we need some definitions.
Equity, for people, is what you have that is worth money or that has grown in value. Homes are the most common types of equity. If you have a mortgage of $150,000 and the house is valued at $200,000, you have $50,000 in equity.
Cars and boats generally don’t have equity as they lose value over time. Stocks, jewelry, artwork, and similar items may or may not have equity. It depends on how much you bought it for and how much someone is willing to pay for it.
An asset is like equity but includes your after-tax income. We are going to use asset and equity to mean the same thing.
Debt is what you owe. Loans, credit cards, mortgages, student loans, and similar items feed into debt.
Debt to Equity Ratio
A ratio compares one value to another. The debt to equity ratio compares how much debt you have to how much equity you have. The formula is below.
If you owe $100,000 and have total assets of $200,000, you have a debt ratio of ½ or 0.5 or 50%. If you have total debts of $200,000 and an equity of $100,000, you have a debt ratio of 2 or 200%. The lower the debt to equity percentage, the better you are situated.
Debt to Asset Ratio
Most lenders use debt to asset ratio as a clearer look at debt to equity ratio. This adds in your after-tax income for a better idea of how easily you can repay your debts.
You can figure out debt to assets two ways. The first is all debt except mortgage. The second is with a mortgage. Let’s break it down with some numbers.
Without mortgage: Add together all debts (loans, credit lines, credit cards, etc.) and divide by after tax income. Let’s say you have $10,000 in debts and an after-tax income of $59,000 (the median US income). Your debt ratio is 0.17 or 17%.
With mortgage: Add together all debts plus the total of 12 monthly mortgage payments and divide by after tax income. Now you have $10,000 in debt plus $12,360 (based on US averages) in mortgage payments. Your debt ratio is now 0.38 or 38%.
What is a Good Debt to Equity Ratio?
Now that you have some numbers, what do they mean? The ideal debt to equity ratio, using the formula above, is less than 10% without a mortgage and less than 36% with a mortgage.
If you exceed 36%, it is very easy to get into debt. Most lenders hesitate to lend to someone with a debt ratio over 40%. Over 40% is considered a bad debt equity ratio for banks.
High and Low Debt Ratios
When you look at debt to equity ratios, a high ratio means you probably don’t have enough equity to cover your debts. A low ratio means you can take advantage of your equity to take out loans if you want.
How to Improve your Debt Ratio
Possibly the easiest way to improve your debt ratio is to pay off debt. If you have credit card debt in excess of $10,000 and are having trouble paying it down, Pacific Debt, Inc may be able to help you out.
Contact one of our debt specialists for a free consultation.
For more information, talk with one of our debt specialists today.
Disclaimer: We are not attorneys or accountants and can not give you legal advice. If you have legal or tax questions, you should contact the appropriate expert.