Calculation of the debt ratio
Taking out a loan is not a step to be taken lightly. This is an operation which is often necessary but which can prove to be risky both for you, the borrower, but also for the lender. This is why it is important to ensure beforehand of its ability to repay by the operation of calculating the debt ratio.
What is the calculation of the debt ratio?
It is the operation to know what weighs in the budget the amount of loan repayments of any type of the borrower. Roughly speaking, the calculation of the debt ratio is the proportion of the monthly loan payments over the monthly net income.
However, each credit institution has its own criteria for calculating the debt ratio. Some take into account all the household's recurring charges (eg tax charges, rents, etc.). In reality, it is a confusion that is often made between debt ratio and remains to be lived; we will come back to the distinction between these two concepts later.
How to calculate the debt ratio?
Most financial organizations, or comparators of credit offers, provide their own tool for calculating the debt ratio. It is then sufficient to fill in the requested information.
However, it is possible to carry out oneself, in advance, his own calculation of the debt ratio. This is even strongly recommended to prepare your project as well as possible and realize the importance of the situation. Indeed, as you will see later, the debt ratio is generally the basis of the request for a loan. In all cases, when putting together your loan application file, the lender will calculate the debt ratio.
This calculation of the debt ratio is done in several steps:
- First, you have to calculate the monthly income. In the case of fixed income, the operation is relatively simple. If your income varies each month, take an average of these over the last fifteen months - however, be aware that the income entered on a tax notice is taken into account more by credit organizations than pay slips.
- Then, group all the current loans and calculate the amount of the monthly payments. It is important not to fool the lender at this point. Indeed, not only the latter would refuse you the granting of the credit but also would register you on a "black list" preventing you from obtaining a new loan, or even it could cancel a credit already granted. Once all the monthly payments have been obtained, add up all the due dates using the amortization tables. These can be obtained free of charge from your lender.
- Finally, you can proceed to the calculation of the debt ratio by the operation: Total monthly payments / Total monthly income . Usually the result is expressed as a percentage (we get a number with two decimal places that we multiply by 100).
For example: A household has monthly payments of € 600 and monthly income of € 2,800. Its debt ratio is: 600/2800 = 0.21 or 21%.
Note: The calculation of the debt ratio on rental investment.
If you have taken out a home loan for a property that you plan to rent, or you are applying for such a case, you are certainly concerned by the rental investment. In this case, the methods of calculating the debt ratio are not the same.
Indeed, the bank will only take into account the net rental income in order to take into account the property charges - i.e. 70% of the rent that you will receive. It is true that the operation can turn out to be complex at the application stage since the current average rent must already be taken into account. In addition, to calculate the future debt ratio, organizations differ depending on whether or not they practice income compensation.
To be clearer, let's take a simple example. A household has € 4000 monthly income and monthly loan payments of € 800. They plan to subscribe to a mortgage whose monthly payments will be € 500 and which will bring them € 300 in rent per month.
If the lender practices income compensation, the calculation of the debt ratio will be done according to this operation:
Either: / 4000 = 0.25 or 25% debt ratio
If the lender practices the non-compensation of income, the debt ratio will be calculated according to this operation: (Current monthly payments + monthly rental financing payments) / (Net rental income + taxable income)
Either: (800 + 500) / (300 + 4000) = 0.30 or 30% debt ratio
What is the benefit of calculating the debt ratio?
The primary interest in calculating the debt ratio is whether the lending financial institutions will grant you your credit. The latter will not commit if the applicant's future debt ratio, taking into account the new loan, exceeds 33% since this index makes it possible to ensure the financial solvency of the borrower.
Also, it conditions the credit rate: the more the calculation of the debt ratio reveals a low result, the more the credit rate will be and the more the monthly payments will be reduced. Indeed, your file will appear to be sufficiently secure for the creditors to guarantee the financial transaction.
However, calculating the debt ratio can prove useful beyond the simple assumption of loan demand. Indeed, it allows you to check your personal situation in the face of debt risk. It is therefore useful for making important decisions: revising expenditure, better managing the budget, or even initiating an over-indebtedness procedure in the most serious cases.
What is the difference between the calculation of the debt ratio and that of the "remainder to live"?
The remainder to live is an important concept and to be defined when one is interested in the calculation of the debt ratio. It corresponds to what the household has to live when it has paid its fixed and incompressible monthly charges.
Its calculation is relatively simple. It corresponds to the household income from which the fixed charges are subtracted. By income we mean wages (or equivalents: unemployment benefits, pensions, etc.), allowances, etc. The regular monthly charges include rent, housing charges (energy, insurance, etc.), taxes, loan repayments, pensions paid and transport costs.
Financial organizations, when studying the loan application, do not simply take into account the monthly payments of current loans. Indeed, it is the remainder to be lived which will make it possible to measure the financial capacity of the borrower, that is to say the money which will be intended to repay the credit and therefore the additional debt amount. This is why the calculation of the debt ratio is essential but not sufficient - also, the calculation of the debt ratio can be satisfactory when the remainder to live is not high enough to contract a new loan without being threatened with over-indebtedness as shown in the following example:
A household consists of two people earning € 1,200 and € 1,400 per month respectively. They took out a car loan with a monthly payment of € 370. Their rent and charges come to them at 950 €, their transport costs at 140 € and their taxes at 300 €. They want to apply for a mortgage to finance the purchase of a second home.
Let's calculate the debt ratio: Total monthly payments / Total monthly income = 370 / (1200 + 1400) = 14%. A priori, their request should be accepted because this rate is less than 33%.
Now, let's calculate their remainder to live: Income - Fixed charges = (1200 + 1400) - (370 + 950 + 140 + 300) = 2600 - 1760 = 840 €. To obtain their rate of remainder to live, it suffices to calculate: Remainder to live / Household income = 32%.
Admittedly, there is no reference rate of remainder to live since everyone does not have the same income. However, it should be borne in mind that the smaller the source of income, the higher the rate of remaining-to-live must be. However, here, the rate of remaining to live obtained is relatively low, which indicates a risk of over-indebtedness which can frighten financial organizations. But this would not have appeared with the simple calculation of the debt ratio. It is therefore clear that the calculation of the debt ratio alone is not relevant in the loan application. However, it remains essential.
What if the calculation of the debt ratio is not favorable to me?
As we saw earlier, financial organizations refuse credit applications when the calculation of the debt ratio leads to a result greater than 33%. One of the solutions is the grouping of credits: an organization will group together all the loans to form a global one. There will then be only one monthly payment per month which will be recalculated according to the current repayment capacity of the household.
This solution makes it possible to manage loans as well as possible and in general to review reimbursements downwards. Thus, the recalculation of the debt ratio should lead to a lower result. However, credit consolidation is not a quick fix; this is why the calculation of the debt ratio must be carried out first and foremost as part of the management of its budget and not only when the question of a loan application is raised.