Do you know your debt-to-equity ratio? If not, you probably should. Determining your debt-to-equity ratio will help you better understand your overall financial health. It’ll allow you to see what lenders and other people who check your credit see: whether you’re a good candidate for a loan, an apartment rental, or a job, or if your debt situation makes you a high-risk proposition.
Understanding your debt-to-equity ratio can also help you determine where you need to focus in order to get your financial house in good order. Here’s what you need to know about your debt-to-equity ratio, and how to fix it.
The debt-to-equity ratio: A definition
The debt-to-equity ratio is a tool to measure the amount of debt a company or individual is holding in relation to assets, or equity. Get the ratio by dividing the total amount of outstanding debt you have by the amount of your assets, or equity. In a simple example, a person with $150,000 in outstanding debt and total assets, or equity, of $250,000, has a debt-to-equity ratio of 60%.
So, what’s a bad debt-to-equity ratio?
How to know if you’re in trouble
When it comes to debt-to-equity ratios, 80% tends to be the magic number. If your debt-to-equity ratio reaches that number, consider it a warning sign that you’re in dangerous financial territory. Lenders are going to consider you a risk and may not be willing to provide you loans or extend you credit.
Unfortunately, many young adults find themselves in 80% territory when first starting out. Most people do not begin their adult lives with significant assets in the bank, and often buy homes with a minimum down payment; this almost certainly will give them a high debt-to-equity ratio. You can fix this situation over time, however. After a few years of paying down a mortgage, and carefully avoiding additional debt, you can bring a high personal debt-to-equity ratio into acceptable territory.
Reducing your debt-to-equity ratio
If you calculate your debt-to-equity ratio and determine it’s 80% or more, you should consider taking action to lower it. Failing to do so may make it hard to obtain credit for important purchases, such as a home or a car, and could even cost you job opportunities. Here are a few things you can do to improve your debt-to-equity ratio if you find yourself in perilous territory.
Track your debts more closely
One of the biggest problems people have is just keeping track of all their debts. Gather all your records and write down the balances of all outstanding debt, including mortgages, other loans, and credit cards. Ensure you know how much your monthly payments are on all of them as well. Finally, to check your work, obtain a copy of your credit report. The report will give you a good understanding of what creditors see, and it may help you spot a debt that you forgot about. Use this information to help you stay focused on debt reduction.
Make a plan
After you look at your debts, determine the best way to start paying them down. In some cases, additional focus may be all you need to commit more money each month to pay down your debts and improve your debt-to-equity ratio. You should also create a debt payoff strategy to help you commit your resources more effectively. It may make sense to pay off your debts from smallest to largest, committing more and more money each month to each successively larger debt. However, if you have debts with excessively high-interest rates, it may make more sense to pay those off first.
When you analyze your debt-to-equity ratio for the first time, you may realize you’re in over your head and don’t have a way pay them all off; at that point, it may make sense to get some help. Some borrowers consider using a debt consolidation loan, which wraps all their outstanding debts into a single low-interest loan. While this will not lower your debt-to-equity ratio, it’ll make it easier to handle all your debt payments.
Other borrowers consider using the services of a debt settlement company, which works with creditors to address outstanding debts. Still others may attempt to work with credit counselors. Finally, borrowers who are in particularly dire financial straits with no realistic way of paying off their debts may declare bankruptcy.
Finding a measure of financial health
If you don’t know your debt-to-equity ratio right now, you should take the time to calculate it. You can be certain that your potential creditors will. Your debt-to-equity ratio is a great tool for determining whether you have the right balance of assets and debt, or if excessive debts are putting you into a dangerous position. Gather all your credit card and loan statements , pull up the calculator on your smartphone (and maybe even our handy debt calculator), and calculate your debt-to-equity ratio today.