An important parameter under consideration, when evaluating the loan repayment abilities of a household, is the debt service ratio, which is explained here.
Jun 16, 2019
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Managing the finances of a household or a business is a tightrope walk. You need to maintain the balance between income and expenses, while ensuring that adequate cash is available for developmental purposes and contingency plans.
Accounting, monitors and keeps track of all financial dealings and follows the money trail from source to destination. When an individual applies for a loan with a bank, his/her financial status is scrutinized intensely. One of the parameters, which is calculated as part of the scrutiny is the debt service ratio of the individual or business.
The household debt to service ratio is obtained by dividing the sum of annual mortgage payments, other debt payments, and property taxes, by the total income of the household. The household gross domestic ratio is obtained by dividing the sum of total mortgage payments and taxes, by the total household gross income.
In case of a business, the total debt service ratio is the total debt owed by a company, to its net income. All these ratios are calculated as percentages. For a country, this ratio is obtained by dividing the total debt payments of the country, by its export earnings.
Whatever be the entity (household, business, or country) for which you are evaluating the ratio, a value which is less than 40% means that the debt is manageable and the entity has adequate incoming cash flow to pay off the debts. On the other hand, if the percentage is greater than 50%, the debt burden may not be easily manageable.
Total Debt Service Ratio = (Property Taxes + Annual Mortgage Debt Payments + Other Debt Payments)/(Gross Yearly Family Income)
Gross Debt Service Ratio = (Annual Mortgage Payments + Property Tax Payments)/(Gross Yearly Family Income)
Greg and Lisa are a couple whose annual mortgage debt payments are USD 30,000, while they pay USD 5,000 in property taxes. Their annual income is USD 300,000 and they pay about USD 40,000 to clear other debt payments. What is their total debt to service ratio?
Total Debt to Service Ratio = (USD 30,000 + USD 5,000 + USD 40,000)/(USD 300,000) = (USD 75,000/USD 300,000) = 0.25
So the ratio for this couple is 25%, which is certainly manageable, as long as they can maintain the same amount of yearly income.
Thus the debt to service ratio reflects the fiscal status of an individual or a business and helps banks and other financial institutions evaluate their repayment capability. At a domestic, business, and national level, it reflects the repayment ability, and provides a clear idea of the debt burden of any entity.