Long-term debt ratio is a calculation that lenders use to determine how much a borrower can handle in terms of debt. It is also known as a debt to income ratio. Potential loan repayments are calculated against the customer’s income to determine affordability. There are two types of long-term debt ratios that lenders use: front-end and back-end debt. Long-term debt ratio is also used by investors to determine the stability of a company.
This ratio determines how much of your gross income is used to cover your rent or mortgage each month. It includes the principal, interest, taxes and insurance you pay. You total those items and divide the figure by your monthly income before taxes to get the ratio or percentage of your income that is taken up by housing payments. The lender will have its own maximum percentage, generally around 28 percent, that your projected payment cannot be above to be approved for a mortgage.
A back-end ratio determines the percentage of your income that goes to other types of debt payments. This ratio involves totaling all of your debt, including housing expenses, credit cards, child support payments and car loans, and dividing it by your gross monthly income. This figure does not include regular expenses, such as food and utilities. This ratio will generally be higher than your front-end ratio (typically around 40 percent) because it includes more debt. Lenders use this ratio to determine whether you can afford to take on additional debt in the form of loan payments.
Why They Are Useful
Long-term debt ratios are good indicators of your financial health. They can tell a lender whether you are living within your means or not. Lower ratios are more favorable because they indicate that you are paying off less debt, which frees up your income for other things. A back-end ratio above 50 percent is financially dangerous, according to Investopedia.
Long-term Debt Ratio in Business
Long-term debt ratios are calculated slightly differently for businesses, but they are still indicators of financial health. Excessive debt increases volatility and limits a company’s options, according to The Motley Fool. For a business, you calculate the long-term debt ratio by dividing a company's long-term debt by shareholder equity (total assets minus total liabilities). Investors look for a ratio of 0.4 (40 percent) or less, though some companies are very successful with much higher ratios, according to The Motley Fool.