Steadfast FinancesPersonal Finance Equations You Should Know: the Leverage Ratios

Personal Finance Equations You Should Know: the Leverage Ratios

Filed in 20s , Debt Reduction , Mortgages , Personal Finance 1 comments

If you’re a believer in The Stuff You Own Ends Up Owning You philosophy, it’s only natural that you should spend a few minutes of every month actually calculating how much, if any, that you’re leveraged and how much of income goes solely to repay your debts.

Yes, I know that for many, topics like these can be depressing, but even if you find that you’re leveraged to the hilt and in debt up to your eyeballs, it doesn’t mean your leverage ratio and debt to income ratio aren’t worthwhile personal finance metrics to track with your money manager software.

So aside from being excellent anti-stuff metrics to track, they’re also fairly good predictors of your financial stability, your creditworthiness when applying for additional credit/loans, and if you’re something of a take-charge personality, they might serve as a source of motivation to put yourself on track for a debt free lifestyle.

The Leverage Ratio

The leverage ratio is quaint mathematical way of quantifying how much you owe versus your annual income.

Where…

Total Debts and Liabilities = mortgage payment, student loan debt, automobile debt, credit card debt, personal loan debt, child support, litigation related debt, etc.

Total Income = Primary job income, second job income, passive income, stock/bond dividends, child support, etc.

Obviously, the lower your leverage ratio, the more solid your finances will be.

Using the Leverage Ratio

If you’re a relatively young person (< 40 years of age) and you have a mortgage, a car, a family, or basically anything that resembles a contemporary lifestyle, the sum of your debts and liabilities likely be larger than your annual income. So don’t be shocked if your leverage ratio is somewhere in the 2.0 to 3.0 range.

For example, let’s say you’re a young professional making an annual salary of $65,000. However, you also have $180,000 left on your mortgage, $10,000 remaining in student loan debt, and you’ve got got $20,000 in auto loan debt.

Your Leverage Ratio would be:

Leverage Ratio = ($180,000 + $10,000 + $20,000) / $65,000

Leverage Ratio = 3.23 or 323%

Thus, even though you’re making an above average salary, you’re still fairly highly leveraged considering your debts total 3.2 times your annual salary.

However, just because you’re highly leveraged, doesn’t mean you’re making a mistake. In fact, the leverage ratio can be somewhat deceiving because as long as you can make your minimum monthly debt repayments, you’re building equity in an asset that you may own free and clear someday (house, car, etc.) or have received/are receiving a valuable service/skill (college education vs. student loan debt) that will continue to pay dividends well into the future.

The problem lies when you have acquired a substantial portion of so called “bad debt” (although one can argue there is no “good debt”) acquired by poor financial judgment, negative social behaviors, or acquiring more consumer related debt than your income allows that doesn’t positively affect your future earnings power or net worth.

The Debt to Income Ratio

Essentially, the DTI ratio calculates how much of your monthly paycheck doesn’t belong to you, but belongs to your creditors until your debts until your debts are fully repaid plus amortized interest (bank profits).

So if you’ve ever applied for a mortgage, or any other type of loan for that matter, you’ve probably your debt to income ratio calculated right and didn’t even know it.

Where…

Total Debts and Liabilities = mortgage payment, student loan payment, car payment, credit card minimum payments, child support, etc.

Total Income = Primary job paycheck, second job paycheck, passive income paycheck, stock/bond income, child support, etc.

Obviously, the lower the ratio the better.

Using the Debt to Income Ratio

Just like the leverage ratio, the debt to income ratio is very simple to calculate. All you need to know is the sum of your monthly debts divided by your gross (pre-tax) monthly income.

Using the example above of the young professional making $65,000 per year (or $5416.66 per month), let’s assume his monthly debts are:

DTI Ratio = (Mortgage Payment + Student Loan Payment + Car Payment) / Gross Monthly Income

DTI Ratio = ($1250.00 + $100.00 + $450.00) / $5416.66

DTI Ratio = 0.33 or 33%

While 33% is an excellent number considering this example has the mortgage already factored in, it is somewhat deceiving in that this liberal version of the DTI doesn’t include many real world expenses, such as: purposely excluding the full costs of home ownership (utilities, HOA fees, etc.), using pre-tax income instead of post-tax income because borrowers can qualify for a larger home.

So why use this liberal method of calculating DTI? Because that’s what a mortgage lender would do if you were applying for a home loan (the so called 28/36 rule).

Therefore, the resulting DTI ratio isn’t nearly as conservative as it probably should be considering that you don’t have the luxury of liberal accounting when you’re paying your bills every month.

If you want to make this ratio more conservative using more realistic numbers, you should consider using real world expenses just as you would when calculating you monthly cash flow. I say this because  where you are using the sum of all real world expenses, your total bring home income (after taxes, 401k contributions, etc), and other debatable monthly “debts” like your car insurance and home owner association fees, the real debt to income ratio will be much higher.

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Posted by CJ   @   25 February 2010 1 comments
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