Debt. It’s a word that often carries a negative connotation. We’re frequently advised to avoid it, yet for many of life’s significant milestones—such as purchasing a home with a mortgage—taking on debt becomes almost inevitable.
Rather than viewing debt as inherently bad, it helps to see it as a financial tool. When used wisely, debt can support our goals and even enhance our wealth over time. However, the key lies in managing it responsibly to ensure it doesn’t compromise our financial health.
A critical metric for assessing our ability to handle debt effectively is the “debt ratio.” Commonly used to evaluate the financial health of companies, this concept is equally valuable in personal finance. By applying it to our own situations, we can gain insights into whether the debt we carry is within manageable limits.
Understanding The Total Debt-To-Total Assets Ratio
One of the simplest ways to measure your overall debt burden is the total debt-to-total assets ratio. This straightforward calculation gives you a clear picture of how much of your assets are offset by your debt.
To determine your debt-to-asset ratio, follow these steps:
First, calculate your total debt: Add up all your financial obligations, including loans, credit card balances, and any other outstanding debts. Next, calculate your total assets: Sum the value of your assets, such as savings, property, investments, and CPF funds.
Now, divide your total debt by your total assets. The result is your debt-to-asset ratio, typically expressed as a percentage. For example, if you have S$500,000 in total debt and assets worth S$1 million, your debt-to-asset ratio would be 0.5 (500,000 ÷ 1,000,000) or 50%.
While there’s no universal benchmark for what constitutes a healthy ratio, a general rule of thumb is to keep it below 50%. A lower debt-to-asset ratio suggests a more fiscally conservative and sustainable financial position. By maintaining your ratio below this threshold, you’ll have greater confidence in your ability to manage debt responsibly while safeguarding your financial stability.
The Debt-to-Income Ratio: A Real-World Perspective On Debt Management
While the debt-to-asset ratio provides a broad overview of your financial health, the debt-to-income ratio offers a more practical and actionable insight by measuring how your debt obligations align with your income and cash flow.
In reality, debt is repaid in regular installments—typically monthly. Similarly, most of us receive income on a monthly basis, especially if we’re salaried employees. This makes the debt-to-income ratio a key tool for understanding how debt repayments affect your monthly cash flow.
To calculate your debt-to-income ratio:
First, add up your monthly debt payments: Include all monthly debt obligations, such as mortgage payments, car loans, credit card minimums, and other recurring debt payments. Next, divide by your gross monthly income: This is your total income before taxes and deductions.
The result, expressed as a percentage, reflects the portion of your income that goes toward servicing debt.
A “good” debt-to-income ratio is generally 35% or less, indicating that your debt is well-managed and unlikely to strain your finances. A ratio above 40%, however, is a red flag, suggesting that your debt load might be approaching unsustainable levels and could impact your financial stability.
By keeping an eye on this ratio, you can better gauge whether your current debt is manageable or if adjustments are needed to ensure your financial health remains on track.
How To Leverage Debt Ratios For Wealth Building
Understanding the key debt ratios is one thing, but how can we use them to enhance our wealth-building efforts over the long term?
#1 Reduce Your Debt Burden
A foundational step in wealth building is reducing your overall debt. Lowering your debt ratios to more favourable levels strengthens your financial position and accelerates your net worth growth over time.
One effective strategy is to increase your monthly debt repayments, if feasible. Paying off debt faster reduces your total liabilities, improves your cash flow, and frees up disposable income for other financial priorities.
#2 Consolidate or Refinance Debt
If you manage multiple debts or high-interest loans, consider debt consolidation or refinancing to secure a lower interest rate. This can significantly reduce your monthly repayments, making it easier to manage your debt while lowering your debt-to-income and debt-to-asset ratios.
#3 Increase Your Income
Boosting your income is just as critical as reducing debt. Whether through career advancement, side hustles, or freelance work, growing your monthly earnings strengthens your cash flow and helps you tackle debt more efficiently. Improved income also allows you to invest more and accelerate wealth accumulation.
#4 Monitor and Adjust Regularly
Use debt ratios as tools to track your progress. Regularly calculating and analysing your debt-to-asset, debt-to-income, and net worth ratios can provide insights into areas that need improvement, enabling you to stay aligned with your financial goals.
By combining debt reduction strategies with efforts to increase income, these ratios become more than just numbers—they evolve into a roadmap for achieving long-term financial success.
Read Also: 4 Ratios To Determine The Value Of A Stock
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