“Live within your means”. This phrase has been used historically to suggest that you should only spend on what you can afford now. So much so, that loans have been demonised as a purely negative thing. However, this school of thought is changing with the realisation that loans can be a powerful tool to achieve your goals. If used in the right way, not all debt is bad debt. We have explored the topic of why debt is important and how it can be used positively in our recent post.
That said, like everything else, moderation is key. It is imperative to ensure that the loans you take are aligned with your ability to pay it back without hampering your financial health. So the question is how much debt is too much debt? This is determined by the debt servicing ratio, commonly referred to as debt to income ratio.
Debt Servicing Ratio
Debt servicing ratio is the percentage of your monthly income that is being used to pay your equated monthly installments (EMI). Total Debt Servicing Ratio (TDSR) factors in mortgage and non-mortage EMIs as well.
Example: Let us say Raj has a gross monthly income of Rs 1,00,000. He has the following EMIs:
- Mortgage: Rs 20,000
- Study loan: Rs 5,000
- Car loan: Rs 10,000
- Credit card loan: Rs 2,000
Total EMI = Rs 37,000
How much should the debt servicing ratio be?
Debt servicing ratio should ideally be 35% or below. Anything above that is considered high. Values of greater than 50% are considered critically high.
What does the debt servicing ratio tell you?
Debt servicing ratio essentially tells you how manageable your debt burden is. Having a high debt servicing ratio indicates either too much borrowing or high interest borrowing. This leads to a very high pressure on your income and compromises your ability to save for other goals like retirement or kids’ education, since most of your income is being spent on repaying loans. It also ill-equips you to handle unforeseen circumstances such as loss of job or a medical emergency, as the debt burden remains the same, but cash flow might be affected.
This is however not recommended for more structured loans such as mortgages, where EMI is pre-determined and agreed upon. It is not financially the best option to increase the EMI for such loans as any changes to loan the structure usually incurs costs. Refinancing, in that case, might be a good alternative to consider to bring down your interest cost and pay up the loan sooner.
How does the debt servicing ratio impact your ability to get loans?
Apart from your credit score and having a stable income, debt servicing ratio is an important factor that determines whether or not you get a loan. A high debt servicing ratio makes it harder for you to borrow, becoming prohibitive for very high values. For example, most banks in India disqualify a mortgage loan applicant if the ratio is above 40%.
Bottom Line
We have come a long way from the mindset of “living within your means”. Loans are a beneficial tool to upgrade and grow your wealth if used in the right way. However, it is imperative to ensure that the amount of loans you take do not hamper your financial health and long-term stability. The debt servicing ratio is meant to simplify the process of determining the overall impact of loans on your finances – in the short and long run. A low debt servicing ratio translates to “borrowing within your means”. Whether you’re someone who already has loans or looking to get one, make sure you leverage this key metric to inform your decision-making.