Debt to Disposable Income Ratio

Debt-to-disposable-income ratio draws on the time-honored financial virtue that advises people to live within their means and remain debt-free. The metric helps lenders screen borrowers, setting those with a high default risk apart from potential creditors with clean financial health. Creditors also factor in this ratio to evaluate such key factors as creditworthiness and credit scores.

A debt is a financial obligation a company or an individual must honor. Also known as a liability, a debt can be financial or non-financial. When a person or organization guarantees a borrower’s debt, the guarantor is liable if the creditor defaults. Accountants distinguish two types of debt: short-term and long-term. Short-term, or current, debts become due in a period that does not exceed one year. Examples include credit card debt, accounts payable and commercial paper. Long-term liabilities mature after 12 months and run the gamut from bonds payable and mortgages to notes due. Financial managers record debts on a balance sheet, also known as a statement of financial position or statement of financial condition.

Income represents revenue that a business derives from its operations -- either by selling products, providing services or doing both. Individuals generate income through earnings from labor contracts. Other sources of income include gains from investment activities, such as sales and purchases of stocks and bonds. Financial accountants record income items in the statement of profit and loss, also known as an income statement or P&L. Other P&L components include manufacturing costs and administrative expenses. Accountants deduct expenses from income to calculate net income -- or net loss, if expenses exceed revenues. Disposable income, an outgrowth of income, equals an individual’s net income.

Debt-to-disposable-income ratio equals a person’s total debts divided by disposable income. For example, a person has $5,000 in monthly disposable income and $2,000 in monthly debt payments. The individual’s debt-to-disposable-income ratio equals 40 percent, or $2,000 divided by $5,000 times 100. Various groups calculate and analyze this metric to identify borrowers who will remain solvent in the near term and those who will not last, financially speaking. In practice, most lenders follow internal tools to gauge credit risk, and every institution has its own benchmark. However, personal-finance experts often recommend at least a 50 percent debt-to-disposable income. This means that a person has at least $1 for every 50 cents of debt outstanding.

Lenders, such as real estate financiers, use debt-to-disposable-income ratio to identify borrowers who could default on their mortgage payments down the road. Business creditors pay attention to debt-to-income ratio -- the corporate equivalent of debt-to-disposable-income ratio -- to gauge a company’s ability to remain financially healthy and meet its monetary obligations.