What Is the Meaning of Total Debt Ratio?
Total debt ratio is a term used frequently in the financial world. This term is often used when applying for a mortgage or car loan, or for filing for bankruptcy. In either example the total debt ratio will be the same even though it is being used for two totally different purposes.
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Function
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The function of a total debt ratio percentage is to determine how much indebtedness you are carrying and what kind of financial risk you are. This will give a lender or bankruptcy court an idea of where you stand in your finances. Theoretically, this number will show whether you are a financial risk or in good financial standing.
Calculations
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To determine your total debt ratio first add up all of your monthly debt payments such as your car payment, student loans, minimum credit card payments, and house payment or rent. Next, add up all of your monthly net income (after taxes and deductions). Some lenders will use your gross income but, to be safe, use your net income. Alimony, bonuses and commissions can be included as income. Divide your total monthly bills (liabilities) by your total monthly income (assets) to see what your ratio is. For example, a person making $2,000 per month in income who has $800 per month in debt would have a total debt ratio of 40 percent ($800 divided by $2,000). Banks prefer this number be 36 percent or below, and ideally around 20 percent, to qualify for a loan. For an easy-to-use online debt ratio calculator, see the Resources section.
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Effects
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Your total debt ratio number can affect your ability to get insurance, credit and determine what interest rate you can obtain on loans and credit cards, as people with a low total debt ratio percentage can obtain lower interest rates than a person with a high debt ratio percentage. In the case of a bankruptcy filing, if the total debt ratio number is too low you can be denied the right to file for bankruptcy.
Types
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Total debt ratio percentages can be used both for personal finance and business finance. Some more common business ratios are debt-to-equity ratios, return ratios and liquidity ratios.
Prevention/Solution
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Check your total debt ratio number throughout the year. This can keep you from getting in over your head and alert you when you may be taking on too much credit. If your total debt ratio percentage is nearing 36 percent, take preventative measures to get your debt paid back down and resist taking on any new debt.
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