Have you ever gone to the bank and they said your debt service ratios were too high? Or that your ratios were very low? Today we cover why listening to your bank (and this ratio) is a very bad idea when deciding whether to get a loan or not.
David Moffatt (00:00):
Hello, everyone. I hope you're doing exceptionally well. Welcome back to the Escaping Debt Podcast. My name is David Moffatt. I'm your host today as always.
David Moffatt (00:09):
Today, we're going to be talking about debt service ratios and how largely they're meaningless, useless, they don't really give a good indication of somebody's financial stability, and how you really shouldn't be relying on them, or a bank to tell you what you can afford for debt payments.
David Moffatt (00:31):
Remember, that our goal is that no consumer should have to struggle with the overwhelming burden that debt causes, and we believe that it's simply not possible to work for both the creditors and the consumer at the same time in an unbiased fashion, and that's why we work for you, not your creditors.
David Moffatt (00:47):
Let's dive into this a little bit more, and you might hear some clicking in the background just because I've actually got a bunch of information pulled up here into what exactly is a debt service ratio, right? Like what are we even talking about? These terms might be largely unfamiliar to a lot of people. Essentially, let's define what a debt service ratio is first.
David Moffatt (01:08):
A debt service ratio is a calculation that a bank does to determine whether you can afford a payment or not. For example, you go into a bank, and you want to apply for $20,000 loan. They will calculate what's known as your gross debt service ratio, as well as your total debt service ratio. These are slightly different, but the principle is the exact same. They essentially calculate how much you're spending on the payment itself in relation to your income, and then your total obligations, okay?
David Moffatt (01:47):
They'll take into account all of your debt payments, your mortgage payments, the utilities on your house, for example, and they divide that into your income. In most instances, these formulas are used primarily when lending on mortgages. However, as I understand, that they are used when you go in for just a regular loan itself.
David Moffatt (02:07):
I'm going to be talking about these primarily in the concept of going to get a mortgage, however, these still apply largely when you're looking at a personal unsecured loan. Let's kind of go through these calculations, okay?
David Moffatt (02:21):
Let's start out with just your regular gross debt service ratio, which is really the cost of the individual property that you're going to be purchasing, okay? For example, they take your mortgage payments, the property taxes, your heating costs, any associated condo fees if you're purchasing a condo, and you're dividing it into your gross annual income.
David Moffatt (02:46):
The total debt service ratio, which is usually what they'll calculate if you're going to get an unsecured loan, is all of your household expenses, any credit card payments that you're paying, and other loan payments like car payments, mortgages, second mortgages, all this type of stuff, and then you're dividing it by your gross annual income.
David Moffatt (03:04):
Now, these guidelines depend and change a little bit per bank and for what you're planning on doing, but the number you get is a percentage. Here's the problem with this stuff, okay, is that you'll notice that, although I mentioned taxes, I mentioned the property taxes, and you're now dividing this formula by the gross income that you end up making, so what ends up happening in a lot of instances is that people are just, just shy of being able to qualify for a mortgage.
David Moffatt (03:39):
I'm looking at the CMHC guidelines in the page, and I'll put this in the show notes, that says that CMHC normally restricts debt service ratios to 35% for the gross debt service ratio, and 42% for the total debt service ratio. To kind of put this in common language, the gross debt service ratio, as it relates to properties, calculates the cost of that individual property, okay?
David Moffatt (04:08):
It essentially says, "How much does this house cost in relation to your overall income?", and the total debt service ratio, and to kind of back up a little bit, that gross debt service ratio, it omits other forms of debt, okay? The total debt service ratio takes into account the entire cost of all of your debt situation, okay?
David Moffatt (04:38):
It'll factor in loan payments and credit card payments and everything like that, that I've already mentioned, but here's the issue with all of this type of stuff, okay, is that when you get paid, there are a ton of deductions. The first one that many people are aware of are just your regular income taxes.
David Moffatt (04:58):
Income taxes in this formula are not taken into account at all, okay, which means that theoretically, somebody that makes a reasonable and sizeable income, I would say, more sizeable than reasonable, they could theoretically eat up a ton of their disposable cash flow just in the taxes that they have to pay. I'll use my own situation back when I was in the military.
David Moffatt (05:26):
Back when I was in the military, I was making about $65,000 a year. This is all public knowledge. You can look it up, and when I run what I was supposed to make, just through an income tax calculator, you take $65,000, you put it through an income tax calculator, I should have been receiving almost $10,000 more per year after taxes than I actually was.
David Moffatt (05:59):
Now, most people would be like, "Okay. Well, this doesn't make any sense. If you were supposed to receive it, why weren't you?" It'll become clear in a second. Well, it's because of everything that was coming out of my pay, so there's obviously the tax that come off. There's the pensions that we ended up having to pay for.
David Moffatt (06:17):
A little known fact, you actually pay for your pension when you're in the military. It isn't something that you get for free. Medical costs can come off of pays, and in the military, you get free medical, at least while you're in, so this is more talking about a regular pay. Any type of dues, so we had mess dues, for example, and you think of just a regular individual that's out and about. They might have regular union dues, they might have mandatory fees that they end up having to pay.
David Moffatt (06:48):
I mean, there's all kinds of costs that don't get factored into this debt service ratio that an individual might have to pay. When I was looking at my income, I was losing nearly 50% of my pay, okay? If you follow this whole debt service ratio calculation, especially when you look at the total debt service ratio that calculates everything ... By the way, this formula worked. I was losing roughly 50% of my income, okay? I could max my service ratios up to 42% in relation to a house, meaning that I would have roughly 8% of my income left to pay for groceries and the gas, and all the other expenses that come with life, right?
David Moffatt (07:39):
I hope that makes sense, and it'd be easier to visualize this if we had a screen share or something like that, but I hope it makes sense. Long story short, this debt service ratio doesn't take into account the actual true costs of life, and the largest cost of life for many people is taxes, the various deductions that come off of their pay that might not necessarily be related to taxes, so again pensions, medical plans, union dues, long-term disability, this type of stuff.
David Moffatt (08:11):
It doesn't take into account cable, internet, phones, your family size. Like for example, the gross family income of a household may be 75,000, which for a family of two, would probably be a very, very, very comfortable salary to make, but if you're now a family of six or seven, that 75,000 starts to become really restricted because your grocery bill goes through the roof. This service ratio doesn't take any of that into account, which means that is this really a good way to actually lend people money?
David Moffatt (08:44):
Well, according to the bank, it is, and the bank will give you a loan if you fit within this 42%, even though your expenses might far exceed what you actually have available, but you might just fit into this calculation. We see this time and time again, where people are lent money, that they really couldn't afford from the get-go, but again, because of these calculations, it ends up working just fine, right? I don't believe that you should be using these calculations when making your decisions to borrow money.
David Moffatt (09:21):
I don't think you should be listening to your banker as to whether you should borrow money. I think you should be listening to yourself, potentially a financial advisor if you're working with one, and I think that instead of calculating debt service ratios, I think you should be going through, making a proper budget, and going through an entire money management plan, and actually figuring out what's affordable.
David Moffatt (09:49):
Now, affordable doesn't mean that when you write your income at the top, that your remaining money at the bottom says $0, especially if you haven't saved anything. A proper effective money management plan has you putting aside money, okay, so make sure that you're prioritizing these types of things, because what this means is if you properly plan and properly calculate how much you can actually afford to pay, then what will end up happening is you'll live a much, much better life. It'll be filled with less stress, right?
David Moffatt (10:28):
You imagine if you get into a house and you can barely afford it because, in my example, I was losing 50% taxes, deductions, pensions, you name it, all my pay when I was in the military, and I can max out my debt service ratio to 42% of my annual gross income, leaving me roughly 8% left to live, and let's just calculate how much 8% actually is. Give me a second here.
David Moffatt (10:59):
8% would be $5,200. According to this calculation, okay, I would have been able to feed myself, buy gas, have a cellphone or a phone, internet cable, I'd been able to just go buy regular household things, and I would've only had $433 a month to do that.
David Moffatt (11:23):
Now, interestingly enough, from what we've seen, the average person spends about $250 a month on groceries, so let's subtract that, so now, I have $183 left. Say cellphone plan, let's say it's cheap, $50, that's cool, so now I have $133 left, and that's for everything. You got to understand this, right? Like obviously, this makes absolutely no sense, and so I don't actually know why CMHC and these banks use this formula.
David Moffatt (11:56):
If anything, if they were to use this formula, they should make these calculations say closer to, I don't know, 25 or 30%. Now, here's the thing, is they'll never do that. The reason why they'll never do that is because the basis of the economy is people purchasing things, and a lot of the economy is based on people borrowing money to purchase the goods that they want to purchase, which means that the last thing that you want someone to do is to not be able to borrow as much at least from a governmental level and from a banking perspective, and banks make money lending money, right?
David Moffatt (12:32):
Long story short, this was a short one today, but you shouldn't be relying on the banks to tell you what you can afford. You shouldn't be relying on a formula to tell you what you can afford, instead, you should be working out a proper money management plan, you should be going through making sure you have room for savings, and what wind up happening is you don't have to care about these numbers.
David Moffatt (13:00):
If you properly plan and you ever need to borrow money, you'd walk in and you should be properly prepared, because of the fact that you'll be well ahead of wherever they're at. Now, I'm not going to lie, this does take effort. It does take time to establish, but I truly believe that anybody can get there if they put their mind to it. Guys, I know this is a short one today. Thank you very much for listening.
David Moffatt (13:25):
We'll catch you in the next one, and always remember that our goal is to make sure that no one has to struggle with the overwhelming burden that debt causes, and this is very true when we're talking about debt service ratios because it is what puts people into a lot of debt. Remember that we believe that it's simply not possible for someone to represent and work for both the consumers and the creditors at the exact same time in an unbiased fashion, and that's why we work for you, not your creditors. Catch you in the next one. Have a great one. Bye.