How much debt is too much?
My colleague Tricia French and I are working on a writing project together and I felt strongly that this information must be shared because of the debt crisis that his happening. Many lenders will treat the amount of debt you can afford like a math problem.
Lenders use two ratios to determine the amount of debt a borrower can manage: Gross Debt Service Ratio (GDSR) and Total Debt Service Ratio (TDSR). The word “service” refers to monthly payments – the amount of money needed to service (pay) certain expenses such as housing and consumer debt.
- Gross Debt Service Ratio (GDSR) looks at the proportion of your income that is required to pay your basic housing costs. It includes the total cost of housing payments (principal, interest, taxes, and heating) divided by the family’s total gross income. Your GDSR should not exceed 32%. Spending a greater portion of your gross income than 32% can make it difficult to cover other expenses. This can be called having a “housing burden”.
- Total Debt Service Ratio (TDSR) looks at the proportion of your gross income that is required to cover basic housing costs and all other consumer debts. It is the percentage of your gross monthly income that will be used for housing and other outstanding loans and debts. Lenders will usually allow up to a 40% TDSR, and it is rare to be able to borrow from a good lender, such as a bank, if your TDSR is above 40%.
Gross income is your income before deductions such as income taxes, Canada Pension Plan premiums, Employment Insurance premiums, and workplace benefits. For most borrowers, a TDSR of 40% would equal more than half of their take-home pay. So, as income declines for most people in retirement, what was manageable before retirement, is likely not manageable after retirement.
Keep in mind that the GDSR and TDSR are guidelines lenders rely on when extending credit. Consumers need to judge for themselves what amount of debt they can manage. Don’t let your lender be the judge of what you can afford. Use your budget and your gut!
Look down the road – are there any factors that may impact how much debt you can afford? Are you planning to help out your kids, start your own business, reduce your work schedule or retire from work? Changes in lifestyle can reduce income and strain the budget. For example, if you are planning to retire in the next few years, borrowing should be limited to what you can afford on your retirement income.
When you are working, your ability to borrow hinges on your employment or self-employment income. In retirement, borrowing will be based on guaranteed forms of income. Lenders consider fixed types of income when extending credit, including work pensions, Canada Pension Plan benefits, Old Age Security, and annuity income. Retirement incomes drawn from investments such as RRSPs, RRIFs, or non-registered investments are neither fixed nor guaranteed, so most lenders exclude them from your income calculation. While you do not want to borrow more than you can afford to pay in retirement, it is easier to establish your access to financing, such as a line of credit, before you retire from work.
If you will carry your mortgage or other debt into retirement, before leaving work, critically analyze whether you can manage your expenses on your retirement income. If it will be tight, discuss with your lender ways to bring your debt in line with your anticipated retirement income. Wait too long and qualifying may be much more complicated.
Once you work out your retirement price tag, it may become clear that your current debt is not manageable in retirement. To make that assessment you need to first, learn to determine if your debt level is too much and second, learn ways to manage and reduce debt.
SPOTTING THE DANGER
E.E. Cummings said “I’m living so far beyond my income that we may almost be said to be living apart.”
Certain debt management behaviours can indicate if your debt is starting to control you. Ask yourself:
- Are you only able to make the minimum payments on your debts?
- Has your debt been increasing?
- Have you missed debt payments or had to take advantage of the “miss-a-payment” feature on your loans or mortgage?
- Have you used a cash withdrawal from one credit card or line of credit to pay another?
- Are you at or near the limit on most of your credit cards?
- Have you obtained new credit because your current credit cards or lines of credit are at the limit?
- Have you borrowed additional money since consolidating your debts?
- Have you received a call from a lender looking for missed payments?
- Have you borrowed money from friends or family to make ends meet?
- Are you unable to set aside even a small amount of savings for a rainy day or emergency?
- Do you feel as though you are living from paycheque to paycheque?
If you answered “yes” to more than a couple of questions, it’s time to look at solutions and perhaps get some professional advice. Do not underestimate the value of working with a professional, such as a Financial Counsellor, to find solutions to debt problems and save time, stress, and money.