How to check your financial health: I
How to check your financial health: II
How to check your financial health: III
This is one grey area of your financial health that you would do well to stay away from. What am I talking about?
Your debt situation.
Have you over borrowed or do you still have some safety margin where you can dare to borrow more? What is your comfort zone? Do you want to venture in the dangerous territory where you will get entangled more and more in the vicious loop of debt?
I am sure none of us would want to be in this situation. But the key question is: how do you avoid such a situation?
You do not have to be a genius or financial wizard to figure this out. All you need to do is analyse a simple ratio: your debt to asset ratio.
Not only do you need to compare your debt with your assets but also need to check whether you have any surplus left after paying your equated monthly installments, EMIs. You can check this with the use of two simple ratios, which will help you in avoiding financial trouble.
They are:
- Total debt to gross income ratio and
- Total annual non-mortgage debt to gross income ratio
Let us understand each ratio in detail.
Debt to asset ratio
It is the percentage of total assets of an individual that goes towards payment of debt. This ratio is calculated by dividing your total liabilities by total assets
Debt to asset ratio = Total liabilities / Total assets
Where, total liabilities include:
- Personal loan
- Car loan
- Home loan
- Money taken from private moneylenders
- Consumer durable loan
- Credit card outstanding
- Any other form of loan or liabilities you might have taken
And total assets include:
- Cash/ Near cash assets like savings account, fixed deposit and liquid funds
- Invested assets (market value) which includes your share investments, PPF, bonds, real estate investments, mutual funds and any other investments
- Personal assets include your house, jewellery, car/ scooter and others
Debt to income ratio
It is the percentage of consumer's income that goes towards payment of debts. This ratio is calculated by dividing total annual debt payments by total annual take home salary.
Debt to income ratio = Total annual debt payments / Total annual take home salary
Where, total annual debt payments includes yearly EMIs for your:
- Personal loan
- Car loan
- Home loan
- Money taken from private moneylenders
- Consumer durable loan
- Credit card outstanding
- Any other form of loan or liabilities you might have taken
And total annual take home salary includes:
- Your business/ Professional income
- Salary
- Bonus receivable
- Dividend or interest payment
- Rental income
- Any other form of income
Non-mortgage debt to gross income ratio
It is the percentage of consumer's income that goes towards payment of non-mortgage debt payments (like say personal loans). This ratio is calculated by dividing total annual non-mortgage debt payment by total annual take home salary
Non-mortgage debt to gross income ratio = Total annual non-mortgage debt payment / Total annual take home pay
Total annual non-mortgage debt payment includes yearly EMIs for your:
Personal loan (considered as non-mortgage loan because there is no security unlike a home loan where the property is mortgaged with the lender)
- Money taken from private moneylenders
- Consumer durable loan
- Credit card outstanding
- Any other form of non-mortgage loans you might have taken
Total annual take home pay includes:
- Your business/ Professional income
- Salary
- Bonus receivable
- Dividend or interest payment
- Rental income
- Any other form of income
Having seen these calculations, let us check the debt to asset ratio every individual should have.
Assuming that you have an outstanding personal loan amount of Rs 4 lakh and an outstanding home loan of Rs 15 lakh, and your total liabilities are Rs 19 lakh. The value of your total assets is Rs 1.5 crore. Your total annual take home pay is Rs 7 lakh. The yearly EMI for personal loan is Rs 1,14,180. The yearly EMI for home loan is Rs 2,47,956.
This takes your total annual debt payment to Rs 3,62,136 (Rs 1,14,180 + Rs 2,47,956).
1. Then, your debt to asset ratio would be equal to19,00,000/15,000,000 *100 = 12.66 per cent
2. Your total annual debt payment to income ratio would be equal to 3,62,136/7,00,000 *100 = 51.7 per cent
3. Your total annual non-mortgage payment to income ratio would be equal to 1,14,180/7,00,000 *100 = 16.3 per cent
But is it good?
In the above example the debt to asset ratio is at 12.66 per cent, which is considered good. The ideal ratio is less than 50 per cent. That is your total debts should not increase more than 50 per cent of your total assets.
The total annual debt payment to income ratio is at 51.7 per cent, which is considered bad. The ideal ratio is 45 per cent. That is your total annual debt payments should not exceed more than 45 per cent of your total annual take home salary.
The total annual non-mortgage payment to income ratio is 16.3 per cent. The ideal ratio is 15 per cent. That is your total annual non-mortgage debt payments should not exceed 15 per cent of your total annual take home salary.
What does it signify?
Although your debt to asset ratio is healthy, total annual debt payments to income ratio and total annual non-mortgage payment to income ratio are on the higher side.
Your debt vis-a-vis total assets might seem healthy but that's against your total assets. Your yearly outflow towards debt payments is on the higher side indicating an unhealthy sign. In such a case you should not borrow more as that will put you in a very uncomfortable position.
So the next time you think of borrowing just do the calculations mentioned above and you will know if you should borrow or not. This will not only check your total debts but also help you in leading a healthy financial life.
Next week: Solvency ratio
How to check your financial health: I
How to check your financial health: II
How to check your financial health: III
The writer is a certified financial planner and can be reached at dhanplanner@rediffmail.com.
