What is the total debt ratio?
Total debt ratio is a metric for calculating the percentage of assets financed by debt. Real estate investors can use this calculation to determine their liabilities and figure out whether their debts are too high. Investors often use it to calculate leverage—the amount of debt an investor has compared to equity. The higher the debt ratio, the more an investor is at financial risk.
Total debt ratio is the ratio of total debt to total assets. If the ratio is greater than one, it means the investor’s debt is funded wholly by assets. If the ratio is less than one, it means equity is funding the investor’s assets.
To calculate debt ratio, you need to divide your total debt by your total assets. Your financial advisor or planner can help you find these numbers. So if you have total assets worth $1M and total debts of $500K, your debt ratio will be 0.5 or 50% (1,000,000 / 500,000). In this scenario, the debt ratio is less than 1, which means equity is funding assets. In real estate, such a ratio might be considered a sign of bad financial health. An investor could find it difficult to borrow additional funds from lenders, for example.
Some lenders use calculations other than debt ratio to determine someone’s liabilities, such as debt service coverage ratio (DSCR). Another metric is gross debt service ratio (GDS), which is the ratio of monthly property costs such as mortgage repayments, taxes, and home insurance to monthly income.
You might notice that the terms “total assets” and “total debt” are ambiguous, and investors often interpret these terms differently. For example, some investors might only include long-term debt when calculating their debt ratio. Nonetheless, this metric can guide investors who want to analyze their debt levels.
Total debt ratio case study
A real estate investor wants to calculate her debt ratio. She has total assets of $500K and total debts of $100K. So she divides her total debts by her total assets. Her debt ratio is 0.2 or 20%. In real estate, a debt ratio of 0.2 might be considered a sign of good financial health. This debt ratio enables the investor to secure additional funds from her lender and expand her real estate portfolio.
The bottom line
Total debt ratio is a calculation that works out an investor’s debt liabilities. You can calculate your debt ratio by dividing your total debts by your total assets. The higher the debt ratio, the more of a risk you are to lenders. However, not all lenders use this calculation when determining your financial liabilities. The terms “total debt” and “total assets” are open to interpretation, and some investors only include long-term debt in their calculations.