Personal finance is all about making the most of your money and ensuring your financial future is stable and secure. Your debt to equity ratio is an important metric that can help you assess your financial health. This ratio compares your debt to your equity and can provide a good indication of your financial leverage.
In this article, we’ll look at what a debt-to-equity ratio is, why it’s important, and how to calculate your own. We’ll also look at some examples of how this ratio can be used to make sound financial decisions.
What Is A Good Debt To Equity Ratio
When it comes to personal finance, the relevant ratio to track would be debt-to-income (DTI) ratio. The recommended DTI ratio is 36% or less. This means that your monthly debt payments, like credit card bills, car loans, and mortgage payments, shouldn’t be more than 36% of your gross monthly income.
To put that in context, imagine you make $5,000 per month. This means that your total monthly debt payments should not exceed $1,800. This includes, of course, all of your monthly debt payments, such as your mortgage, car loan, student loans, and credit card bills.
It’s important to keep in mind that different lenders and financial institutions might have different ideas about what a good DTI is. However, aiming for a DTI of 36% or less is a good starting point for someone looking to keep their debt under control and avoid getting in over their heads.
What is a debt-to-equity ratio?
A debt to equity ratio is a financial ratio that compares how much debt you have to how much equity you have. It measures how much of your finances are financed by debt versus how much is financed by equity.
Your equity is the value of your assets less the amount of your liabilities. For example, if you own a $300,000 home and owe $100,000 on the mortgage, your equity in the home is $200,000. This equity can be used to fund future investments or to repay debt.
Debt, on the other hand, refers to money owed to others, such as credit card debt, car loans, or mortgages. Debt is usually repaid with interest, so the longer you carry it, the more it will cost you in the long run.
Divide your total debt by your total equity to get your debt to equity ratio. The resulting number is expressed as a percentage, which can assist you in determining how much of your financial leverage is derived from debt.
What is the significance of a debt to equity ratio?
A debt-to-equity ratio is an important way to measure your financial health for a number of reasons.
1. It demonstrates how much power you have
The debt to equity ratio can help you understand how much of your finances are financed by debt and how much by equity. A high debt-to-equity ratio indicates that you have a lot of debt relative to your equity, which can be a warning sign that you’re putting too much money at risk.
2. It can assist you in making sound financial decisions
By tracking your debt to equity ratio over time, you can determine whether you’re taking on too much debt or building equity at a healthy rate. This information can assist you in making sound financial decisions such as debt repayment, increasing your savings rate, or investing in assets that will appreciate in value.
3. Lenders can use it to assess your creditworthiness
When you apply for a loan, lenders frequently use the debt to equity ratio to assess your creditworthiness. If you have a high debt-to-equity ratio, you may have to pay a higher interest rate to compensate for the increased risk.
How to Calculate Your Debt-to-Equity Ratio
Calculate your total debt: Add up all of your debts, including credit card balances, car loans, student loans, and mortgages, to determine your total debt.
Total equity is calculated by adding the values of your assets, which include your home, car, investments, and savings. Subtract your total liabilities, which includes your total debt.
Divide total debt by total equity: Once you have both numbers, divide total debt by total equity. The resulting percentage represents your debt to equity ratio.
A Debt to Equity Ratio Example
Assume you have $100,000 in total debts and $50,000 in total equity. To determine your debt-to-equity ratio, divide your total debts by your total equity:
$100,000 / $50,000 = 2
In this case, your debt to equity ratio is 2, indicating that you have twice as much debt as equity.
There is no hard and fast rule in personal finance for determining an acceptable debt to equity ratio. However, financial experts generally recommend that your debt-to-income ratio not exceed 36%. This means that your monthly debt payments (including credit card bills, mortgage payments, and car payments) should not exceed 36% of your gross monthly income.
A debt-to-equity ratio is not commonly used in personal finance to assess financial health. Instead, people typically employ the previously mentioned debt-to-income ratio. That being said, a lower debt-to-income ratio is generally better because it means you have more money left over each month after paying your debts.