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Debt Serivce Ratio Nonsense

December 17, 2011 – Comments (2)

Personal debt levels are through the roof because of a lack of distinction that debt servicing ratios are not created equally.

I noticed this post on Calculated Risk about the debt service ratio is back to 1994 levels.   This is not something to celebrate as if debt levels are back to 1994 levels.

As interest rates decline but the debt service ratio remains constant people's ability to get out of debt is drastically reduced, as I've shown in past posts, http://makingsenseofmyworld.blogspot.com/2008/02/six-degrees-of-leverage.html and http://makingsenseofmyworld.blogspot.com/2007/05/low-interest-rates-as-destructive-as.html

Debt service ratios worked fine before Greenspan started stepping interest rates down.  You could make manageable sacrifices and really reduce your debt obligations by drastically reducing the overall amount of interest you'd end up paying back.  When rates are low most of what you are paying is principal and there is little empowerment to reduce what you actually end up paying back.  A small sacrifice is hardly worth the effort.

Additionally, we think of rates being higher in a higher inflation environment where wages are going up and debt levels relative to wages are declining.  In a low interest environment wages are stagnant.

It's a double hit and it is nonsense to compare debt service ratios in dramatically different interest rate environments.  Somehow the news is implying things are as good as 1994, but this is far from the truth.