What is a Debt Service Ratio (DSR)?
A debt service ratio is a financial metric that measures the amount of cash required to cover the interest and principal on debt obligations.
You can apply it to corporations and individuals when analyzing debt.
The ratio provides valuable insight into a corporation’s or individual’s current debt load, their capacity to take on more debt, and their risk of defaulting on payments.
It’s used extensively by lenders as a risk assessment tool.
In the context of personal finance, the DSR is a helpful tool to gauge how much of your income you dedicate to covering debt payments.
The ratio has direct implications for your capacity to spend, save, and qualify for loan products, so being aware of your DSR is crucial.
Fact
In the second quarter of 2021, the average Canadian household had $1.73 in debt for every dollar of disposable income.
What is Gross Debt Service Ratio (GDS)?
A standard DSR ratio that lenders use to assess whether to issue a loan to a borrower is the gross debt service ratio (GDS).
This ratio measures the percent of your gross household income you use to pay for your housing costs, including your mortgage, property taxes, and heating expenses.
Total Debt Service Ratio vs Gross Debt Service Ratio
In addition to the GDS, the total debt service ratio (TDS) is also a critical metric used by lenders to analyze a household’s debt situation.
Like the GDS, the TDS also measures the amount of your gross household income you allocate to your debt payments.
However, in addition to your housing costs, it also considers your total debt, including credit cards, personal loans, and lines of credit.
Therefore, the TDS is a more stringent assessment of your ability to handle debt than the GDS, which only factors in your housing costs.
How to Calculate Your Debt Service Ratio?
Determining your DSR is straightforward – you simply need to know your annual gross income and debt payments (plus some other costs, as explained below).
The type of debt you incorporate in your calculation will differ depending on which measure you’re looking at (GDS vs TDS).
Here’s the formula to calculate your GDSR
Mortgage principal + Mortgage interest + Property taxes + Heat / Gross annual income
Though the mortgage principal and interest are the only debt components of the calculation, lenders also wish to know your property tax and heating charges, as these are ongoing expenses associated with homeownership.
If you’re renting a condo, you must include 50% of the condo fees in your calculation, as well.
Here’s the formula to calculate your TDS:
Mortgage principal + Mortgage interest + Property taxes + Heat + Other debt / Gross annual income
The process for determining your TDS is identical to the one used for the GDS, except that you must incorporate your other outstanding debt obligations.
These include credit cards, lines of credit, personal loans, auto loans, and student loans.
You may also add alimony and child support payments, if applicable.
How to Interpret My Personal DSR?
The GDS and TDS show the amount of income you use to cover your debt obligations (and other ongoing relevant costs, such as property taxes) expressed as a percentage.
For example, let’s say your annual housing costs are $24,000, and your gross yearly income is $75,000.
In this case, your GDS is 0.32 ($24,000 / $75,000), which means you dedicate 32% of your income to covering your housing costs or 32 cents for every dollar you earn.
The same concept applies to the TDS.
The higher the percentage, the more income you need to service your debt payments, which means the likelihood of you defaulting is higher.
Accumulating too much debt over time can put you in a financially precarious position, so being conscious of how much debt you carry is prudent.
Why is the Debt Service Ratio Important?
Besides being a useful metric that indicates if your debt load is excessive, the DSR is utilized extensively by lenders to gauge the risk associated with approving you for a loan product.
Naturally, lenders want to ensure that the individuals they extend credit can make timely loan payments and are unlikely to default on their debt payments.
A typical scenario where the DSR plays a role in lenders’ decision-making is a mortgage application.
Since a mortgage is a significant and often multi-decade commitment, lenders will scrutinize your debt obligations to assess if you can handle the added mortgage payments.
Suppose you’re in the market for a personal loan, auto loan, credit card, or other similar credit product.
In that case, your DSR will also play a crucial role in whether your application gets approved, especially if there’s no tangible asset that will secure the loan.
If your DSR is too high, lenders will be more reluctant to issue you a loan.
As a result, you’ll face challenges financing the purchase of pricey items like a home or vehicle.
For this reason, you should strive to keep your DSCR at a reasonable level.
Key Insight
The Canada Mortgage and Housing Corporation (CMHC) recommends that borrowers’ GDS and TDS ratios don’t climb higher than 39% and 44%, respectively, to avoid having mortgage applications rejected by lenders.
Frequently Asked Questions
- What is a good debt service ratio?
- What should I count as income in my ratio calculation?
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When calculating your debt ratio, you should include your employment income and pension income.
You can include self-employment income, investment income, and other variable income if you can document that you’ve earned it consistently over two years.
Net rental income can also be added, provided you’re not applying for a mortgage for a property generating rental revenue.
Should the mortgage be for an investment rental property, you can only apply 50% of your gross annual rental income. If you’ll be occupying the rental property alongside your tenants, you can use 100% of your yearly gross income in your ratio.
