Use debt-service ratio to know your financial health

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Like there are several available parameters to evaluate and adjudge the financial health and efficiency of an economy at a macro-level and a company at micro-level, parameter such as the debt-service ratio serves to provide you with useful information concerning your financial health and stability in the long-run. The measure is also made used by different financial institutions to evaluate an individuals capability to service debt obligations in future course.

What is debt-service ratio?

The ratio shows the total amount that goes towards servicing the debt from the total income. Total debt includes all monthly installments or EMIs for all of the loan accounts, credit card etc. The ratio is computed by dividing the loan amount paid on a monthly basis with the total monthly income including interest income. The ratio signifies the extent or degree to which you are trapped in debt.

Illustration showing the computation of debt-service ratio: So, if you have a personal loan, car loan account in addition to a credit card, for which you need to service per month Rs. 2000, Rs. 15000 and Rs. 3000 is the minimum amount due for the credit card transactions made. And if your total monthly income amount to Rs. 40,000 then your debt-service ratio turns out to be 50% (20000/40000*100).

How the debt-service ratio is useful?

The ratio gives you early signs and warns you of any likely credit troubles that may befall you. And the situation thus alerts an individual to take either of the available course of action to meet the situation in case of high debt-service ratio.

In case you are a middle-class, urban citizen financial advisors and experts hold the debt service ratio of 30-35% to be ideal. However, this suggest a ideal scenario and the maximum debt-service ratio of 40% does not much risk to the individual. Nonetheless, any figure in excess of this benchmark of 40% warns of a likely financial trap in the near future. Despite the threshold set for the maximum debt which can be afforded without falling in any financial calamity, it holds that High net worth individuals can afford a certain higher percentage of debt-service ratio.

Furthermore, to keep yourself financially safe you should monitor and track this metric to know your financial health on a regular basis.

Story first published: Thursday, November 21, 2013, 15:04 [IST]
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