The Difference Between Debt To Equity and Debt To Income

The Difference Between Debt To Equity and Debt To Income

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In the world of personal finance, ratios are confusing. There are hundreds of them and very few are applicable to the average person. Some do though, like the debt to income ratio. All too often this extremely important ratio is confused with another, the debt to equity ratio and that’s a problem.

Debt to income ratio divides your total monthly debts by your monthly gross income to give you a percentage that points to your ability to repay a loan. On the other hand, the debt to equity ratio is calculated by dividing companies total liabilities by the shareholder’s equity. Which gives an idea of how likely a company is to default.

See a big difference here? One deals with people on a personal level and the other at a company level. So let’s unconfuse them.

These ratios can essentially evaulate the same thing in how leveraged a person or company is and if they have too much debt in comparison to income. Keep reading to learn why you need to understand these, especially debt to income ratio.

What Is Debt To Equity

Even though the debt to equity ratio isn’t applicable to most of you I still want to give you a quick overview of it. Not because I’m trying to make you into a finance nerd but rather so you can correct others when they use the wrong terminology. Plus I think when people know random stuff like this it is cool.

If you are in corporate finance then this should be ingrained in your brain especially for those of you in accounting roles.

DTE ratios tells potential investors how leveraged a company is with loans vs. the equity (cash, retained earnings, other assets) in the company.

If you have a low debt to equity ratio then you are less likely to default on your debt payments and may be an overall more attractive investment.

This is of course extremely simplified as you should always compare industry averages and dozens of other metrics. Nevertheless it is still important to know.

How Is it Calculated

Since I just want to skim the surface on this topic here is the formula for DTE.

The formula is pretty straight forward but let’s go through an example.

Normally, I would like to make one up and walk through it with you. This is a special occurrence and something that would get quite confusing. Melissa Ling over at Investopedia came up with this great graphic that I wish everyone could see.

If you were an investor who would you rather put your money in? A company with a DTE ratio of 5 or .5?

Later, I’ll show how this is similar to how a lender would evaluate you as a person. To a lender you are the investment and they want to keep that investment as low of risk as possible.

If you want to learn more then Investopedia does a great job of covering this topic in terms anyone can understand.

What Is Debt To Income

If you are looking to purchase anything expensive, specifically a home, then you must understand what your debt to income ratio is and how it works. Sometimes it is referred to as the debt to asset ratio but this isn’t the terminology your banker will most likely use. So we’ll stick to income for now.

Debt to income ratio probably comes in second in terms of importance to a credit score when you apply for a mortgage. Don’t let this fool you though, it is extremely important.

Each lender sets their own limits for who they’ll accept and at what interest rate. Personal loans also consider your debt to income because they want to get paid back. Who wouldn’t?

Since we’re looking at a person’s debt here then we obviously want this number to be as low as possible. Similarly to the debt to equity ratio. From my research the absolutle max you want your percentage to be is 45%. Any higher than that and your chances of being approved for any sort of loan is slim to none.

The ideal amount is 35% and less.

The remainder of this, 65% in this case (100% – 35%), is what your banker believes you need to keep in monthly gross income to survive. This includes your groceries, fast food, and the gas you put in your car. Statistically speaking people spend more than 50% of their earnings on everyday items which is where the 45% comes from.

Special occurrences

Rarely will someone have a DTI of 0%. If so, then they usually have no credit history at all which will also hurt when applying for a mortgage. In fact, the chance of you getting approved without a co-signer is zero. As you’ll see in the next section it’s highly unlikely your DTI will be at 0% unless you live at home. In this case, you are probably too young to be making such a large purchase.

How Is It Calculated

As stated in the introduction your DTI is calculated by taking your monthly debt expenses divided by your gross monthly income. Some examples of monthly debt expenses are:

  • Mortgage or rent
  • Credit card
  • Car loan or lease
  • Student loans
  • Child support
  • Other debts

Add all of these up and you get your monthly debt expenses.

To illustrate this formula let’s run through a quick example.

Let’s say someone makes $4,000 gross income per month ($48,000 per year). This person’s monthly debt expenses include rent ($1,000), car loan ($300), and student loans ($400). All totaling up to $1,700 per month.

Their debt to income ratio would then be ($1,700 / $4,000) x100 = 42.5%.

From the information above we know that 45% is the MAX someone should have when applying for a loan so this person is pushing the limit. If I were to offer them a suggestion it would be get rid of one of those debts as soon as possible. This would most likely be the car loan as it’s the easiest to pay off in comparison.

By doing this their DTI would drop to 35% ($1,400 / $4,000) x100

If this calculation has too many variables going on then jump over to Nerd Wallet’s calculator here it’s quite informative and just a plug and play.

The Bottom Line

Understanding certain key financial ratios are going to make managing personal finances for anyone exponentially simpler. Understanding the debt to income ratio is important for almost everyone but debt to equity, not so much. Never hurts to know things right?

It can be confusing at times but as long as you understand what the % is measuring and how to get to it then you’ll be fine. Moreover, if you do run into the occurrence where your DTI is too high then you’ll now know just what to do to lower it.

As far as other key ratios go I would highly suggest understanding your lifetime wealth ratio and of course, net worth. You can read more about those by clicking these articles:

Lifetime Wealth Ratio and Other Simple Personal Finance Formulas

The One Number That Makes You Rich: Net Worth

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