Debt Service Ratio

Managing the finances of a household or a business is a tight rope 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 is all about monitoring and keeping track of all financial dealings and following the money trail from source to destination. When an individual applies for a loan with a bank, what follows is an intense scrutiny of the applicant's financial status. One of the parameters, which is calculated as part of the scrutiny is the debt service ratio of the individual or business.

What is Debt Service Ratio?

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 income. 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, divided by its export earnings. Whatever be the entity (household, business or country) for which you are evaluating the ratio, a value 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.

Formula

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)

Calculated Example

Greg and Lisa are a couple whose annual mortgage debt payments are $30,000, while they pay $5,000 in property taxes. Their annual income $300,000 and they pay about $40,000 through other debt payments. What is their total debt to service ratio?

Total Debt to Service Ratio = ($30,000 + $5,000 + $40,000) / ($300,000) = ($75,000 / $300,000) = 0.25

So the debt service ratio of 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 household, business and national level, it reflects the repayment ability, provides a clear idea of debt burden and overall financial health.